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.

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.

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.

4

Definitions:

Source Definition

Mutual Fund$ for

Dummie$ 1997

“A mutual fund is a large pool of investment

money from lots and lots of people.”

FSOS Performance

Support New

Employee Orientation

2/1/97

“A mutual fund is a collection of stocks,

bonds, or other securities purchased by a

group of investors and managed by a

professional investment company.”

5

Quarterly Market

Guide to Merrill Lynch

Mutual Funds

“An investment company that pools the

money of many individuals and invests in a

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

Annual Guide to

Mutual Funds 1991

“A mutual fund is an investment company

that pools the money of many individual

investors. When the fund takes in money

from investors, it issues shares.”

Words of Wall Street

1983

“Popular name for the shares of open-end

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.”

6

www.sec.gov/consum

er/inwsmf.htm

“A mutual fund is a company that brings

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

Funds and MLAM

1997

“A mutual fund is a corporation with a state

charter to conduct business as an investment

company. It invests in publicly traded stocks

and bonds, and issues its own shares to

investors, who become Mutual Fund

Shareholders.”

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

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.

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.

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

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.

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

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

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:

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

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

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.

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).

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.

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.

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).

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.

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.

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

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.

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.

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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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.

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:

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.

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].

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

fund

Initially

(January 1)

began with $100,000 in

assets

issued 10,000 shares

had an initial NAV of

$10.00 per share

33

XYZ Biotech

fund

At the end of

the first quarter

of operation

(April 5)

has had no expenses

did not issue or redeem

any shares

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

board of

directors

April 10 decides to distribute all

of the income earned by

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

fund

April 15

(record date)

still has an NAV of

$10.50

34

XYZ Biotech’s

board of

directors

April 16 (ex

date)

Removes the $5,000

from the fund’s assets

and puts it in a pending

dividend distribution

account (this will

decrease NAV by $0.50

per share)

XYZ Biotech

fund

April 16 (ex

date)

now has an NAV of

$10.00

XYZ Biotech

fund

April 25

(payable date)

pays a dividend of $0.50

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:

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

a...

and who places the

trade...

will...

buyer prior to ex date

(April 16)

pay $10.50 per share,

which includes the

$5,000 in income, and

will

be entitled to the

dividend when it pays.

buyer on or after ex date

(April 16 )

pay $10.00 per share,

which does not include

the $5,000 in income,

and will

not be entitled to the

dividend.

36

seller prior to ex date

(April 16)

receive $10.50 per share

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

(April 16 )

receive $10.00 per share

for the liquidation, which

does not include the

$5,000 income, and will

Be entitled to the

dividend when it pays.

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

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.

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

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

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

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.

43

Risk, Return and Performance:

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

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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,

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.

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.

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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".

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

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

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

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.

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.

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

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

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%

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

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.

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

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:

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:

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.

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.

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)

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(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

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)

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:

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):

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.

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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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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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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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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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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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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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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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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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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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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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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