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.

1
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.

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

2
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.

3
Definitions:

Source Definition
Mutual Fund$ for “A mutual fund is a large pool of investment money

Dummie$ 1997 from lots and lots of people.”

FSOS Performance “A mutual fund is a collection of stocks, bonds, or

Support New Employee other securities purchased by a group of investors and

Orientation 2/1/97 managed by a professional investment company.”

Quarterly Market Guide to “An investment company that pools the money of

Merrill Lynch Mutual many individuals and invests in a portfolio of stocks,

Funds 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 “A mutual fund is an investment company that pools

Guide to Mutual Funds the money of many individual investors. When the

1991 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.”

4
 www.sec.gov/consumer/in “A mutual fund is a company that brings together

wsmf.htm money from many people and invests it in stocks,

bonds, or other securities. (The combined holdings of

stocks, bonds, or other securities and assets the fund

owns are known as its portfolio.) Each investor owns

shares, which represent a part of these holdings.”

Sage Online 1997 “A mutual fund is a savings/investment account

managed by money managers employed by an

investment company. Money managers are

professionals who select the investments of the fund.

Introduction to Mutual “A mutual fund is a corporation with a state charter to

Funds and MLAM 1997 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.”

Need for the project:

5
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 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.

6
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.

• Secondary data-

 Internet

 Business magazines

 Workbook

Characteristics of a mutual fund:

7
• 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.

• 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:
8
 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 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
9
 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.

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:

10
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 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:

11
 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 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:

12
1. INCOME FUND SCHEME:

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 which are included in any specific index e.g. the scripts which

13
 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 companies, offshore investments, etc.

5. FUND-OF-FUND SCHEME:

14
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.

15
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).

16
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.

• 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.

17
• 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.

• 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.

18
• 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).

• Closed end fund investors also do not have exit option.

19
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.

• 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.

20
• 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.

• 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.

21
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 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

22
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.

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.

23
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.

24
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.

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

25
‘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:

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.]

26
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.

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.

27
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].

6. Since our share is not liquid we must discount 7 by 10% to give a valuation of Rs.

6.30 per share.

28
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 • began with $100,000 in assets

(January 1) • issued 10,000 shares

• had an initial NAV of $10.00

per share
XYZ Biotech fund At the end of the • has had no expenses

first quarter of • did not issue or redeem any

operation shares

(April 5) • earned $5,000 in interest and

dividends from the assets in

it’s portfolio

• has an NAV of $10.50 per

share

($105,000/10,000=$10.50)

29
 XYZ Biotech’s April 10 • decides to distribute all of the

board of directors 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 • still has an NAV of $10.50

(record date)
XYZ Biotech’s April 16 (ex date) • Removes the $5,000 from the

board of directors 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 • pays a dividend of $0.50 per

(payable date) 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:

30
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 • pay $10.50 per share, which

(April 16) includes the $5,000 in income,

and will

• be entitled to the dividend

when it pays.
buyer on or after ex date • pay $10.00 per share, which

(April 16 ) does not include the $5,000 in

income, and will

• not be entitled to the

dividend.
seller prior to ex date • receive $10.50 per share for

(April 16) the liquidation, which includes

the $5,000 in income, and will

• not be entitled to the

dividend, as the income was

already reflected in the $10.50

NAV.
seller on or after ex date • receive $10.00 per share for

(April 16 ) the liquidation, which does not

include the $5,000 income, and

will

• Be entitled to the dividend

when it pays.

31
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
32
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 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

33
 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.

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:

34
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 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

35
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 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-

36
 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 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.

37
Risk, Return and Performance:

Rate of return is computed as: (Income earned/Amount invested)*100.

38
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

Rs. 27.65 at the end of the year.

%age change in NAV = (27.65 – 23.45)/23.45 *100 = 17.91%

39
• 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, 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.

40
 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.

• 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

41
  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.

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”.

42
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".

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.”

43
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 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.

44
• 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 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
45
 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

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.

46
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.

47
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

• Brokerage and transaction cost

• Registrar service for transfer of units sold or redeemed

• Fees and expenses of trustees

48
 • 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

• Interest on delayed payment to the unit holder

• Legal, marketing, publication and other general expenses not attributable to

any schemes

49
 • 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%

For bond funds, the above percentages are required to be lower by 0.25%.

50
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 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.

51
• 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.

52
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 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.

53
 • 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:

• 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.

54
Accounting Policies:

• 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.

55
• Bonus/rights shares should be recognized only when the original shares are traded on

the stock exchange on an ex-bonus/ex-rights basis.

• 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.

 The following percentage is then computed:

56
 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)

(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.

57
• 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

• 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:

58
• 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)

 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.

59
• 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:

 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.

60
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):

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

61
 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. 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.

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 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.

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

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 6 months past due date of interest i.e. 3 months from the date of classification of asset

as NPA

(01.10.2000)

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:

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 1. In case a company has fully cleared all the arrears of interest, the interest

arrears provisions can be written back in full.

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:

When fund has received income/principal amount after their classifications as NPAs:

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 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.

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’.

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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 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.

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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.

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.

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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 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.

Conclusion:

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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.

Bibliography:

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 • Mutual Funds In India – By H. Sadhak.

• Indian Mutual Funds- By Sundar. Sankaran.

• Business world magazines.

• ASSOCIATION OF MUTUAL FUNDS IN INDIA ( AMFI ) Workbook, Third

Edition.

Webliography:

• www.mutualfundsindia.com

• www.sbimf.com

• www.investopedia.com

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