Accounting Norms for Mutual Funds

Introduction

Mutual funds manage thousands of crores of investors' money, making accurate and transparent accounting absolutely critical. SEBI has prescribed comprehensive accounting norms to ensure uniformity, transparency, and reliability in financial reporting across all AMCs. These norms govern how income is recognized, expenses are allocated, assets are valued, and financial statements are prepared.

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Key Accounting Principles

1. Accrual Basis of Accounting

Mutual funds must follow the accrual system of accounting rather than cash basis. This means that income and expenses are recognized when they are earned or incurred, not when cash is actually received or paid. For example, if a scheme holds a bond that pays interest semi-annually, the interest income must be accrued daily in the NAV calculation even though cash is received only twice a year. This ensures that the NAV reflects the true economic value of the portfolio at any given time.

2. Scheme-Wise Segregation

Each mutual fund scheme must maintain separate books of accounts. The income, expenses, assets, and liabilities of one scheme cannot be mixed with another scheme, even if they are managed by the same AMC. This segregation ensures that investors in Scheme A are not bearing the expenses or risks of Scheme B, and each scheme's NAV is calculated independently based solely on its own portfolio.

3. Mark-to-Market Valuation

All securities in the portfolio must be valued at their current market price (mark-to-market) rather than at historical cost. For listed equity shares, this market price is the closing price on the stock exchange. For debt securities, valuation is done based on prices provided by agencies like CRISIL or FIMMDA. This mark-to-market approach ensures that investors buying or redeeming units on any given day get a fair NAV that reflects current market conditions.

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Revenue Recognition

Income from different sources is recognized according to specific rules:

Dividend Income

Dividend income from equity shares is recognized on the "ex-dividend date" (the date on which the stock starts trading without the dividend entitlement) rather than when the dividend is actually received in the bank account. This is because on the ex-dividend date, the scheme has earned the right to receive the dividend even if the actual cash comes later.

Interest Income on Bonds

Interest on debt securities is accrued on a daily basis using the effective yield method. For example, if a scheme holds a bond paying 8% annual interest, the scheme accrues 8%/365 = 0.0219% interest income every single day. This daily accrual ensures smooth NAV movements rather than sudden jumps when interest is received semi-annually.

Capital Gains

Realized capital gains (when a security is sold) are credited to the scheme immediately upon the sale transaction being completed. Unrealized gains or losses (increase or decrease in value of securities still held) are automatically reflected through mark-to-market valuation in the daily NAV.

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Expense Allocation

Investment Management Fee

The fee paid to the AMC for managing the portfolio is the largest component of expenses. It is calculated as a percentage of the scheme's average Assets Under Management (AUM) and is deducted daily from the NAV in proportion. For example, if the annual management fee is 1.5% and the NAV is ₹100, then approximately 1.5%/365 = ₹0.0041 is deducted from NAV each day.

Registrar and Transfer Agent Fee

The fee paid to the RTA for maintaining investor records and processing transactions is also allocated daily to the scheme based on the actual services rendered during that period.

Other Operating Expenses

Expenses such as custodian fees, audit fees, legal charges, and marketing costs are allocated to schemes based on rational principles:

• Direct Expenses: Expenses incurred exclusively for one scheme (like scheme-specific marketing) are borne entirely by that scheme
• Common Expenses: Expenses benefiting multiple schemes (like AMC office rent) are allocated proportionately based on each scheme's AUM or transaction volume

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NAV Calculation Methodology

The Net Asset Value is calculated daily using the following standardized formula:

NAV per unit = (Total Assets - Total Liabilities) / Number of Outstanding Units

Calculation Steps:

Step 1: Value All Assets

• List all securities held (stocks, bonds, money market instruments)
• Value each security at current market price using SEBI-prescribed valuation norms
• Add cash and bank balances
• Add accrued interest on bonds
• Add dividend receivable from stocks

Step 2: Calculate Total Liabilities

• Management fees payable to AMC
• Registrar fees payable to RTA
• Custodian fees
• Outstanding expenses
• Payables for units to be redeemed

Step 3: Compute Net Asset Value

• Total Assets minus Total Liabilities = Net Assets of the Scheme
• Divide Net Assets by total number of units outstanding
• Result is NAV per unit (rounded to 4 decimal places)

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Financial Statements and Reporting

Half-Yearly Unaudited Financials

Every six months, AMCs must prepare and send unaudited financial statements to all unit holders showing:

• Portfolio holdings and their market values
• Income and expenditure during the period
• Changes in NAV
• Portfolio turnover ratio
• Expense ratio and its components

Annual Audited Report

At the end of each financial year (March 31), a comprehensive audited annual report must be prepared by Chartered Accountants and sent to all investors. This report includes:

• Audited balance sheet and income statement
• Auditor's report certifying the accounts
• Detailed portfolio statement
• Top 10 largest holdings
• Investment performance vs benchmark
• Expense ratio breakdown
• Related party transactions disclosure

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Case Study: Franklin Templeton NAV Calculation Error (2015)

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Comparison: Accrual vs Cash Accounting

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Audit and Compliance

Internal Audit

AMCs must have an internal audit function that:

• Reviews daily NAV calculations for accuracy
• Verifies that all income and expenses are properly recorded
• Checks compliance with investment restrictions
• Ensures proper scheme-wise segregation of accounts
• Reports findings to trustees quarterly

Statutory Audit

A qualified Chartered Accountant firm (independent of the AMC) must:

• Audit the annual accounts of each scheme
• Certify that accounts are prepared as per SEBI norms
• Verify NAV calculations on sample basis
• Report any irregularities to trustees and SEBI

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Exam Notes: Writing the Answer

Question: "Explain the accounting norms prescribed by SEBI for mutual funds." (10 Marks)

Model Answer:

SEBI has prescribed comprehensive accounting norms to ensure uniformity and transparency in mutual fund financial reporting.

Key Accounting Principles:

1. Accrual Basis: Mutual funds must follow accrual accounting where income and expenses are recognized when earned/incurred, not when cash is received/paid. This ensures NAV reflects true economic value daily.

2. Scheme-Wise Segregation: Each scheme must maintain separate books of accounts. Assets, liabilities, income, and expenses of different schemes cannot be mixed, ensuring investors in one scheme don't bear costs of another.

3. Mark-to-Market Valuation: All securities must be valued at current market prices daily. Listed equities at closing price, debt securities based on CRISIL/FIMMDA valuations. This contrasts with historical cost accounting.

Revenue Recognition:

• Dividend: Recognized on ex-dividend date (not receipt date)
• Interest: Accrued daily using effective yield method (e.g., 8% bond = 0.0219% daily)
• Capital Gains: Realized gains booked immediately on sale; unrealized gains reflected through mark-to-market

Expense Allocation:

• Investment management fee: Calculated as % of average AUM, deducted daily
• Direct expenses: Charged wholly to specific scheme
• Common expenses: Allocated proportionately based on AUM across schemes
• Must be within SEBI-prescribed TER limits

NAV Calculation: Daily calculation using formula: NAV = (Total Assets - Total Liabilities) / Outstanding Units. Published by 9 PM daily.

Financial Reporting:

• Half-yearly unaudited statements to all unit holders
• Annual audited report by Chartered Accountant
• Portfolio disclosure showing holdings, performance, expense ratio

Example: Franklin Templeton (2015) failed to accrue expenses daily, charged lump sum at quarter-end causing NAV distortion. SEBI penalized and mandated NAV correction and investor compensation.

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Summary

• Accrual accounting mandatory: Income/expenses recognized when earned/incurred, not when cash flows
• Scheme-wise segregation: Separate books for each scheme, no mixing of assets/liabilities
• Mark-to-market: Daily valuation at current prices (not historical cost)
• Revenue recognition: Dividend on ex-date, interest accrued daily, capital gains when realized
• Expense allocation: Within TER limits, direct expenses to specific scheme, common expenses proportionately
• NAV calculation: (Assets - Liabilities) / Units, computed and published daily by 9 PM
• Reporting: Half-yearly unaudited + Annual audited reports to all investors
• Audit: Internal audit (ongoing) + Statutory audit by CA (annual)

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Quiz Time! 🎯

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