In calculating fund expense ratios, funds may only reduce total expenses by contractual fee waivers or reimbursements, the SEC is reminding fund advisers in its annual, "Dear CFO" letter.
A review by the SEC of funds' financial highlights and fee tables revealed that some funds were miscalculating their expense ratios by reducing total expenses by brokerage offsets, custodial credits and other expense reductions, according to the letter. Some funds were also neglecting to include interest and dividend expenses attributable to securities sold short from a fund's total expense figure, the letter said.
The chief accountant's office of the SEC's division of investment management has mailed its "Dear CFO" letter to fund company financial officers and fund auditors. The purpose of the regulator's year-end letter is to clarify accounting-related issues that have cropped up during the past year. The Dec. 30 letter from chief accountant John Capone, addresses eight accounting and reporting issues.
This year's letter also provides guidance for instances when a fund adviser has receivables on its books related to an agreement between the fund and its adviser to reimburse the fund for certain expenses. In such cases, fund management must consider how likely it is that the expense reimbursement will be collected, said the SEC. Fund firms should consider reducing the outstanding receivable balance for potentially uncollectible amounts. If expense reimbursements are outstanding, fund officials should consider deducting the amount owed from the fund adviser's management fee or the adviser's seed capital redemption, said Capone.
"We are trying to avoid fund advisers from owing the fund money," he said.
In examinations of several fund groups, the SEC found that some funds which have expense reimbursement plans in effect with the fund's adviser, are continuing to post receivables that have been outstanding for longer than a year, Capone said.
The SEC also responded to questions from several advisers regarding when seed money necessary to launch a fund could be withdrawn. According to law, new funds must be infused with a minimum of $100,000 in assets, invested in the initial shares offered by the fund. But the initial investor, most often the fund sponsor, is barred from seeding the fund with capital with the sole intention of redeeming or otherwise disposing of this investment.
Many fund advisers have erroneously believed that there was a five-year waiting period for holding onto these shares, said Capone. That five-year period was, coincidentally, the time frame during which advisers could recoup the costs incurred in introducing a fund. Consequently, some fund advisers mistakenly believed that seed money could only be withdrawn after the fund's five-year anniversary. But, in fact, no such requirement exists, said the letter.
The confusion was compounded when, in April, 1998, the American Institute of Certified Public Accountants, the accounting industry trade group, removed the five-year requirement during which companies could capitalize and amortize organizational costs, Capone said. That change had no connection with or impact on the withdrawal of a fund's initial capitalization, said the letter. The letter said that each fund's circumstances are different.
"The legality of a sponsor redeeming seed capital shares depends on the facts and circumstances of the redemption and is not based on the accounting for organization costs," the SEC letter said.
The SEC also offered guidance on accounting for offering costs when a hybrid or "interval" fund is introduced. The SEC said an interval fund may continue to capitalize its start-up costs as long as it possesses both distribution fees, resembling 12b-1 fees in open-end funds, and withdrawal charges, that are akin to contingent deferred sales charges for open-end funds.
Interval funds, first allowed by the SEC in 1992, have some characteristics of both open and closed-end funds. They resemble open-end funds in that their shares are continuously offered. But, they restrict redemptions to pre-set, regular monthly or quarterly intervals unlike open-end funds, which can be redeemed on any day. Also, interval funds have illiquid portfolios like closed-end funds.
The SEC's comments come in response to the Financial Accounting Standards Board's announcement in September 1998 that closed-end funds could no longer capitalize and amortize their initial costs because they were not receiving 12b-1 distribution fees and deferred sales charges, Capone said.By law, closed-end funds are not allowed to charge 12b-1 fees.
According to the SEC's "Dear CFO" letter, some advisers to interval funds objected to being held to the amended accounting standards promulgated specifically for closed-end funds.