Investment Funds and Fund Accounting

Investment fund accounting is important for investors in mutual fundsincluding individuals, pension funds, family investment funds as well as institutional investors like Hedge Funds and Private Equity funds etc. The purpose of fund accounting is to correctly record transactions, monitor related custodian accounts in order to accurately evaluate a fund's portfolios and calculate Net Asset Value (NAV) including unit price of each holding whilst ensuring compliance to applicable regulation. The operation of UK Authorised Investment Funds is governed by comprehensive legislation. This article highlights the regulatory and reporting framework with emphasis on key technical considerations for for-profit funds. Non-profit organisations are outside the scope of this blog.

The Financial Reporting Council (FRC) UK promotes high-quality corporate governance and reporting to foster investment and enable users of accounts to receive high-quality and easily understandable financial information that’s relevant to their needs.

The Investment Association (IA) [previously the Investment Management Association (IMA)] is the trade body that represents UK investment managers. The IA shares the FRC’s aim of high-quality financial reporting and has been recognised by the FRC for the purpose of issuing SORPs for UK Authorised Funds. The IA have noted that - the recommendations of the SORP are not an alternative for referring to the relevant regulations and FRS. The SORP should be read in conjunction with the FRC Statement “SORPs: Policy and Code of Practice”, any rules and regulations relating to authorised funds that are in force, and the law relating to these matters.

The Association of Solicitor Investment Managers (ASIM) exists to encourage the provision of high quality investment services by solicitors for private clients, trusts and charities.

The Financial Conduct Authority (FCA) authorises and recognises Investment Funds that are structured as collective investment schemes (CIS), before they can be promoted to retail investors in the UK. Authorised Funds, also known as Authorised CIS, can take one of the following legal forms:

• authorised contractual scheme (ACS) – aka tax transparent fund established as a co-ownership scheme or a limited partnership. Normally structured with a number of sub-funds, with own investment managers.
  
• authorised unit trust (AUT) – unit trust that can be offered to the public.
  
• investment company with variable capital (ICVC) – aka open-ended investment company (OEIC) is an umbrella mutual fund where investors put their money into a master fund that then reinvests other funds.
  

A CIS must also be classified based on marketing strategy, as one of the following:

• undertaking for collective investment in transferable securities scheme (UCITS) – fund that that complies with EU Directive that allows a fund authorised in one EU country to be freely marketed in other EU states.
  
• non-UCITS retail scheme (NURS) – doesn’t comply with UCITS directive but approved for UK retail investors.
  
• qualified investor scheme (QIS) – funds subject to less rules because they are only available to experienced investors with higher appetite for risk and meet certain qualifying conditions.
  

Authorised Fundsare investment schemes where unit holdings are approved by the FCA to be promoted to UK public whereby contributions from several investors are pooled in a professionally managed portfolio with the aim of spreading investment risk and generating decent return for investors. The instrument constituting the fund may provide for different classes of unit. However, where this is the case the assets and liabilities of the authorised fund remain as one pool and are not separately owned by any individual unit class.

In SORP 2014, the IA defined Authorised Fund as

• A unit trust scheme which is authorised by an authorisation order under section 243 of FSMA - Financial Services and Markets;
  
• An open-ended investment company (OEIC) incorporated by an authorisation order under regulation 14 of the OEIC Regulations ; or
  
• A contractual scheme which is authorised by an authorisation order under section 261D of FSMA.
  

Investment trusts are companies that pool funds from small investorswith limited appetite for risk, who benefit from the employment of a professional fund manager to invest the pooled funds in a diversified portfolio of securities, thereby spreading the investment risk in a wide range of other funds/securities to gain income and/or capital growth.

The unit investor benefits from economies of scale, regarding admin and dealing costs. Transaction costs include fees and commissions paid to agents, advisers, brokers and dealers; dealing charges, stamp duty, charges to buy/sell, levies by regulatory agencies and securities exchanges, transfer taxes and duties. Direct transaction costs do not include any difference between the quoted bid and offer prices or internal administrative or holding costs.

Some investment trusts are called “fund of funds” and their objective is to invest in other investment trusts. Investment trusts have several special features that make them unique. A good starting point for an individual looking to save money for the future is a stock and shares ISA. The individual savings account (ISA) is a “wrapper” for a range of investments. It is called a wrapper because it has a protection threshold for tax on capital gains, dividends and interest. Returns on investments in ISAs are tax free subject to a yearly limit set by the government.

Other kinds of collective investment vehicles like unit trusts and open-ended investment companies (OEICs) where investors can invest or withdraw from the fund on an ongoing basis; also offer similar risk diversification benefits.

In considering an investment strategy to buy in to, it is very crucial to note that past performance is not a measure of future performance. Although it may indicate fantastic return to date on an investment strategy, it doesn’t necessarily mean that future performance will be just as fantastic. Nothing is certain about the future. In fact, you should never buy an investment trust purely on the basis of past performance. It is absolutely important to always consider other factors including the trust’s operating costs, the level of risk, your own risk appetite and investment objectives, the type and size of the trust, etc.

Also known as investment accounting, this is the maintenance of the financial records for a portfolio of investments like securities, commodities, property or mix of asset classes held in an investment fund. Accurate records must be kept of all the activities of the fund to facilitate fair valuation of instruments held by the fund and proper evaluation of changes in value.

The Fund Accounting framework is directed by the Statement of Recommended Practice (SORP). The objective of the SORP is to provide recommendations for the preparation of the financial statements of all authorised funds. In addition to providing standard interpretations of accounting standards and other legal and regulatory requirements regarding authorised funds, the SORP establishes principles for determining the nature of items of income as revenue or capital for the purposes of both distribution and taxation. SORP applies to the annual and half-yearly reports of all UK authorised funds.

A complete set of periodic financial statements should contain:

• Statement of total return
  
• Statement of change in net assets attributable to unitholders
• Balance sheet
• Statement of cash flows
• Notes to the financial statements

The statements above should be presented with equal prominence. There is no prescribed order in which they should be presented; however, the statement of total return and the statement of change in net assets attributable to unitholders should be presented on the same page, thereby providing unitholders with a summary of the principal features of the fund’s results for the period.

Comparative information for last year should be shown for all items in the annual financial statements, unless permitted otherwise.

Net Asset Value (NAV), Equalisation, Tax Implication,Bond Amortisation

NAV is the value of an entity's assets minus the value of its liabilities. In Fund Accounting, NAV is calculated per unit of ownership (NAV per share) based on the closing market prices of the securities in a fund's portfolio. For withdrawals to be made, the fund manager must calculate the value of each unit held by investors (NAV per share), i.e., NAV calculation divided by total units (shares of ownership) issued. NAV/share = total (assets - liabilities) / number of issues shares. This changes regularly overtime and is not the best measure of a fund’s performance hence should not be relied upon as basis of investment decision.

Decision to invest should rely more on total returns, personal investment appetite, investment strategy of each fund, diversification of investment profile, capital protection, tax exposure, income payment frequency, consider reinvestment of surplus income and capital growth vs. withdrawal based on your risk appetite.

The NAV process ensures that investors share the gains or losses equitably. The NAV cycle tracks funds inflow, issuance of shares, funds outflow for investments and related costs, NAV calculation and withdrawals.

Equalisation is a process used to ensure that income distribution from a fund is the same for all shareholders, regardless of when the shares were purchased. When a fund pays income, the shares are said to be ex-dividend (ex-div or XD), which means excluding dividend, hence the unit price falls. New investors after ex-div date are clustered together as group 2 shares. Pre-existing shares are bundled as group 1 shares.

Shares bought after ex-div date during distribution or accumulation period may include accrued income and are said to be cumulative dividend (cum-div), hence with higher unit prices. The Distribution Period is the period from one ex-div date to the next and could be monthly, quarterly, half-yearly or yearly, depending on the strategy of the income distribution fund. Accumulation Period relates to funds that don’t distribute profit but rather accumulate profits periodically during which the income is added to capital of the fund. Dividend/distribution payments are made just once, typically on the annual accounting period date.

If an investor sells their holding in a fund on the ex-div date or during the ex-div period, their details will remain on the unit holders register and they will receive dividend payment. However, if sold before the ex-div date, the new investor’s details will be added to the register of shareholders on the next update before XD date and the new owner will be paid the dividend. Dividend distribution for the period is determined by calculating the revenue, deducting direct costs and other expenses, taxation and making such other adjustments as the authorised fund manager considers appropriate and in accordance with FCA rules.

At the next payment date, all unitholders will initially be entitled to the same dividend receivable per unit. However, the NAV calculation process allows for adjustment for part of the income payable to group 2 shares. The amount is treated as return of capital into the fund. This is because part of the payment is income accumulated from the date of purchase and the rest is partial return of the amount paid for units bought at higher price during the cum-div period. This partial return on the first distribution or accumulation of income after a purchase, is known as capital repayment or an equalisation payment for capital sum included in distribution/allocation of income for a unit issued, sold or converted during the accounting period in for which that income allocation is made.

A corresponding adjustment may need to be made on disposal of the investment. This process equalises the per unit income payable to group 2 shareholders with that payable to group 1 shareholders that participated in the last ex-div event. After the new ex-div date, group 2 become equalised with group 1 shares. This may have an impact on the tax position of investors as it is regarded as a non-taxable capital return for UK tax purposes, except for units held in tax wrappers like ISAs. The income part is subject to usual income tax. The equalisation (or capital repayment) part will have capital gains tax implications as it has to be deducted from the purchase price of the holding when calculating capital gains tax.

This should not be confused with Amortised Bond where the principal is consistently paid down with accrued interest over the life of the loan like a mortgage.

Amortisation refers to the spread of a payment or the cost of intangible assets like patent, goodwill, copyright or research/development capitalised expense, over a designated useful life, by making planned charges to income over that time period. The technique is also applied to paying down a loan or mortgage, over a predetermined term and reflect current/declining value of the loan over time.

IAS 38 states that - intangible assets (identifiable non-monetary asset without physical substance) should be amortised on a systematic basis over their finite useful lives, in line with paragraph 97. However, according to paragraph 107, where there’s indefinite useful life, the intangible asset shall not be amortised.

Bond Amortisation relates to bonds purchased at a premium or discount. When a bond is sold at a premium, the credit balance in the Premium on Bonds Payable account is amortised and written off to interest expense over the life of the bond. In line with Golden Rule of Accounting, every debit entry must have a corresponding credit entry and vice versa. Hence, in the bond investor’s book, similar offsetting entries are posted. Bonds bought at discount will have significantly higher interest income than those bought at premium to par value. The premium or discount on held to maturity bonds will not be recognised as capital loss or gain. It will be recorded as amortisation/adjustment to interest income generated by the bond over the life of the bond.