introduction to fund accounting script

Introduction to Fund Accounting

The Script


Introduction to Fund Accounting - Learning Outcomes -

At the end of the introduction to fund accounting module participants will be able to

describe what is meant by net asset valuation

discuss why a NAV is calculated explain what is meant by the NAV cycle

describe what is meant by subscriptions and redemptions

discuss some of the implications of a NAV error

describe the key elements of an equity trade discuss the significance of trade date and settlement date

explain how equity positions affect the NAV

describe how interest income is recognised by an investment fund discuss the accruals concept

calculate interest accruals on cash deposits

describe what is meant by cash dividends explain how cash dividends affect the market price of the share

identify when a cash dividend affects the net asset valuation of a fund

describe how fixed and variable expenses are calculated and accrued account for prepaid expenses

explain how expenses affect the NAV

describe how an investment fund prices the instruments held in the portfolio discuss the key elements of a valuation pricing policy

calculate a net asset valuation.

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QuickTrain 1 – Fund Accounting Overview In 7 minutes you will be able to describe what is meant by net asset valuation, why a NAV is calculated and what is meant by the NAV cycle. Open-ended investment funds are funds that allow people and institutions to invest in, or take their money out of, the fund on an ongoing basis. Funds might permit this on a daily, weekly, monthly, quarterly or less frequent basis. Let’s assume we have here a daily dealing fund. This fund allows the investor to invest cash today and withdraw cash any day after today. The investor could have money in the fund for years or could withdraw cash next week. If I invested $100,000 a week ago and want to withdraw all my money now, how much do I get? What is my investment worth? This daily dealing fund must be able to tell me, the investor, what my investment is worth on any given day. So the value of the fund must be calculated on a daily basis. The fund must sum up the value of everything it owns, subtract the value of everything it owes and so calculate a net asset value, a NAV. The NAV calculation determines how much the investor gets when they withdraw some of their investment. How we get from that total fund NAV to my share of the fund depends on how the fund is structured. If the fund is established as a partnership, partnership accounting will allocate gains and losses to my account and on any day the net asset value of my account can be ascertained. If the fund is set up as a company or as a trust it will be unitised. This means that investors are given units or shares in the fund at the time they invest. These shares have a value, a NAV per share. The NAV per share changes over time. The NAV per share at the time of my investment determines how many shares I’m allotted. The NAV per share at the time I withdraw my cash determines how much I get paid. The NAV is the basis upon which investors invest or withdraw cash to or from a fund. It ensures that investors share the gains or losses equitably. Therefore its accuracy is hugely important. Fund accounting refers to the maintenance of the financial records of an investment fund. Accounting records must be kept for the investor activity, the portfolio activity, the income earned and the expenses incurred by the fund. In addition, the instruments held by the fund must be valued regularly and fund accounting records these changes in value. The fund accounting for this activity forms the basis for the net asset valuation and for the preparation of periodic financial statements. Our focus is on the NAV calculation. What is the NAV cycle? • Cash is invested into a fund • The fund issues shares to an investor. • The fund then makes investments in various financial instruments, earns income and incurs expenses • The net asset valuation is calculated. • The NAV per share is the basis upon which subsequent investments and withdrawals are processed. • So the NAV per share determines the number of shares issued to investors and the amount of cash paid to investors That is the NAV cycle. The NAV is the assets of the fund less the liabilities of the fund. It’s calculated so the fund knows how much to pay investors when they withdraw their investment; and to know how many shares to issue to new investors. It is also used to report fund performance. Quick Questions Click on pause to give yourself time to answer. Identify these statements as true or false. All investment funds calculate a NAV per share. This is False. Partnerships don’t. Partnerships calculate a NAV for each partner but only unitised funds calculate a NAV per share or NAV per unit. The only reason for calculating NAVs is to report fund performance. This is false. The NAVs determine how many shares the investors get when they invest. And how much cash investors get when they withdraw from the fund. Assets minus Liabilities equals Net Asset Value. This is true. You should now be able to describe what is meant by net asset valuation, why a NAV is calculated and what is meant by the NAV cycle. When you have completed all 8 QuickTrains in the Introduction to Fund Accounting module, remember to complete the online test. A link to the test is provided at the end of the final QuickTrain.


QuickTrain 2 – Capital Activity There are 8 QuickTrains in the Introduction to Fund Accounting module. This is the second one – Capital Activity. In 7 minutes you will be able to describe what is meant by subscriptions and redemptions, and describe some of the implications of a NAV error. In the context of an investment fund capital activity refers to the cash flows between the investors and the fund. An investment into the fund is called a subscription. A withdrawal from the fund is called a redemption. Subscriptions and redemptions usually take the form of cash. From time to time however an in-specie transaction might take place. In-specie means securities instead of cash. An in-specie redemption for example: instead of paying the investor a cash amount, the investor might be given a portfolio of equities or bonds. Most subscriptions and redemptions however are for cash. Let’s look at an example. It is 1st September and the administrator has just calculated the NAV for 31st August. The 31st August NAV is based on the value of the portfolio as at the close of business on 31st August. The total net asset value is $100 million. There are 1,000,000 shares in issue so the NAV per share is $100. An investor wants to invest $1,000,000. Each share costs $100, the NAV per share. So the investor gets 10,000 shares and pays $1,000,000. Anytime an investor invests money into a fund or redeems money from a fund a contract note is issued. The contract note outlines the terms of the transaction. On this particular note we see the dealing date, the date upon which this subscription was transacted, 31st August, the number of shares issued, 10,000, the NAV per share at which the subscription was processed and the cash amount invested. Be clear about these dates. The NAV here is calculated as at the close of business on 31st August. Fund accounting calculate this NAV on 1st September. The settlement date is 5th September: the investor will transfer $1,000,000 to the fund on 5th September. So the fund created and issued 10,000 new shares on 1st September. But it won’t receive the $1,000,000 until 5th September. The fund will record that it is due to receive that $1,000,000 and reflect the receivable as an asset. Ignoring other fund activity, here is the fund position before the subscription is processed on 1st September. And here is the fund position after the subscription is processed on 1st September. 2 key points here: Firstly, the receivable is an asset and is included in the NAV. Secondly, a subscription or a redemption will affect the total NAV but will not affect the NAV per share. What if the NAV was wrong? Imagine there was an error in the NAV calculation of 31st August. What are the implications? The investor would be allocated the wrong amount of shares. Thereafter, until the error was addressed, the investor would receive incorrect information regarding the value of the holding. In addition to the damage to the fund’s reputation and the resources involved in correcting the error, it is possible that an investor must be compensated as a result of such an error. Clearly, the accuracy of the NAV calculation is of the utmost importance. A subscription is the transaction whereby an investor invests in a fund. A redemption is a transaction whereby an investor withdraws their investment from a fund. A NAV error means fund performance is reported incorrectly. In addition, it could mean an investor is allocated the wrong number of shares or paid a wrong amount of cash. Quick Questions Click on pause to give yourself time to answer. It is 1st October and the administrator has just calculated the NAV for 30th September The total NAV is $80,000,000. There are 1,000,000 shares in issue. An investor wants to redeem 1,000 shares. How much will the investor receive on settlement date? The NAV per share is $80. The investor will receive $80,000. What is the total NAV after the redemption has been processed? $79,920,000 What is the NAV per share after the redemption has been processed? The redemption does not change the NAV per share. It is still $80. As well as the total NAV decreasing, the number of shares in issue decreases proportionately. So the NAV per share remains the same. You should now be able describe what is meant by subscriptions and redemptions, and describe the implications of a NAV error. When you have completed all 8 QuickTrains in the Introduction to Fund Accounting module, remember to complete the online test. A link to the test is provided at the end of the final QuickTrain.


QuickTrain 3 – Portfolio Activity There are 8 QuickTrains in the Introduction to Fund Accounting module. This is the third one – Portfolio Activity. In 9 minutes you will be able to describe the key elements of an equity trade, discuss the significance of trade date and settlement date, and explain how equity positions affect the NAV. Investment funds can trade a range of different financial instruments – equities, fixed income securities, currencies, deposits and many types of derivatives. We’ll focus on equities. Ordinary shares or common stock represent shares in ownership of a company. The holder has voting rights at annual general meetings. Equities could be listed on an exchange - publicly traded - or they could be unlisted and privately traded. When a fund trades equities there are two key dates, the trade date and the settlement date. The trade date is the date the transaction is executed. The settlement date is the date the equities are delivered and the cash is transferred in payment. This fund calculates a NAV daily. On 1st November it buys Oracle shares for $34 per share. The trade will settle on the 4th. So the fund will not actually pay for the shares until the 4th. But trade date is the effective date for accounting purposes. With effect from trade date the buyer is considered to be the owner. So the fund will reflect the position in the portfolio. Also, the fund will reflect the fact that it owes the counterparty the cost of the shares. The end of day price of Oracle on the 1st is $35. On the 2nd November, we calculate the NAV as at close of business on the 1st. In that NAV calculation we reflect the Oracle shareholding and we value it, at $35. Trade date accounting is a key accounting concept. When the fund buys equities it is the trade date that is the effective date of ownership. We account for that trade as if the fund owns the equity with effect from the trade date. With effect from trade date the buyer has the economic interest in the equities and will benefit from increases in the share price and suffer if the share price decreases. Key point – The fund owns Oracle shares with effect from 1st November – the trade date. Now think about the NAV. As at the close of business on 1st November, the fund owns Oracle shares and it is valuing those shares at $35, the closing market price on the day. So the market value of Oracle shares is included in assets. And the fund owes the counterparty to the trade the cost of those shares. This liability will be paid on the 4th. And this liability will be reflected in the NAV until it is paid. We can see the impact of the Oracle trade on the NAV right here. That $1,000 represents the unrealised gain on Oracle shares as at close of business on 1st November. Let’s remind ourselves of those trade details. The fund bought 1,000 shares, total cost $34,000. Fast forward a couple of weeks. It is 15th November and the investment manager decides to close out that Oracle position, that is, the investment manager sells the 1,000 shares. He sells the shares at a price of $37. Total sales proceeds, $37,000. How much has the fund made on these shares? $3,000. And that $3,000 represents the realised gain on Oracle shares. Let’s colour in some more detail on securities trades. Securities have different identifiers. One might use the symbol from a particular exchange or an ISIN or a CUSIP number. Many accounting systems use these recognised identifiers. In reality a trade will incur charges and commissions so the total cost is more than just the number of shares times the price per share. Many investment funds are ‘long only’. Others are sometimes described as ‘long/short’. What do these terms mean? Many investment funds can only buy securities. Buying a security creates a long position. They are long only funds. Other funds can sell securities that they don’t own and thus create what is called a short position. How? They borrow securities, sell them, buy those securities back later and return them to the lender. These funds are permitted to create short positions. Why do they do this? If Google is trading at $1,000 per share and the investment manager believes the share price will fall, the fund can borrow Google shares and sell them for $1,000. If the investment manager is correct, the share price falls. The fund can buy the shares for, say $900, and return the shares to the lender. The fund makes a gain of $100 per share. The fund must pay the lender a stock-lending fee. We will not elaborate further on borrowing stock or on short positions. But remember this: Long positions are securities owned by the fund. They are assets. Short positions are securities owed by the fund. They represent liabilities. Trade date is the day the deal is done. Settlement date is when payment and transfer of securities happen. The buyer owns the securities with effect from trade date. Between trade date and settlement date the buyer owes an amount payable for securities purchased.


QuickTrain 3 – Portfolio Activity (continued) Quick Questions Click on pause to give yourself time to answer. This fund buys AT&T shares. In which NAV are these shares first included? The NAV as at close of business on the 1st, 2nd, 3rd or 4th October? The trade date is the effective date of ownership; they are first included in the 1st October NAV. What is represented by the following formulae? Assets less Liabilities. NAV. Market Value less Cost. Unrealised gain or loss. Sales Proceeds less Cost. Realised gain or loss You should now be able to describe the key elements of an equity trade, discuss the significance of trade date and settlement date, and explain how equity positions affect the NAV. When you have completed all 8 QuickTrains in the Introduction to Fund Accounting module, remember to complete the online test. A link to the test is provided at the end of the final QuickTrain.


QuickTrain 4 – Interest Income There are 8 QuickTrains in the Introduction to Fund Accounting module. This is the one fourth one – Interest Income. In 7 minutes you will be able to describe how interest income is recognised by an investment fund, discuss the accruals concept, and calculate interest accruals on cash deposits. Interest income is revenue generated by the cash deposits or other interest bearing instruments, such as bonds, held by a fund. Income and indeed expenses are accounted for on an accruals basis. This means that income and expenses are recognised by a fund during the period to which they relate, not when the cash is actually received or paid. This is a key accounting concept. Here is a fund that has cash on deposit for all of the month of December and interest is credited to the fund’s bank account in January. The fund earns interest income of €1,000 each day in December. So total interest income for December is €31,000. And €31,000 is credited to the fund bank account on 2nd January. So when does the fund recognise the income? When is the NAV affected? Every day throughout December the fund recognises €1,000 interest income. So the balance on the Interest Receivable Account, an asset account, increases throughout the month. And so, the NAV increases daily as a result. When you think about it, this is fair to the investors. Investor A redeems shares from the fund on 10th December. He should benefit from income earned by the fund up to that date. And he does. The NAV and therefore the redemptions proceeds included income earned. Interest on fixed income securities and cash deposits is calculated as a % of the principal amount. The % is always quoted on a per annum basis and needs to be apportioned for a particular period. Many different day-count bases exist for calculating interest on different instruments. Cash on deposit is often calculated on an Actual/365 basis. Here is a fund that deposits €36,500 at 1%. It earns €365 in a year. In other words, it earns a euro each day. This is called the daily interest factor. In fact, this is a 7-day deposit so it will ultimately earn €7 interest. Our accruals concept tells us that the fund should allocate the interest to the period to which it relates and account for that interest accordingly. In other words, it should recognise €1 each day for the 7 days. All other things being equal, the NAV of the fund will increase by €1 each day for each of the 7 days. The result is that there is not a sudden increase in the NAV as a result of the interest income received by the fund on the 8th November. The fund has smoothed the effect of the interest income over the 7 days and this is fair to investors coming into, or taking their money out of, the fund during that period. Interest income affects the nav during the period to which it relates, not when the cash is received. If a fund has cash on deposit for a month, interest income should increase the nav a little every day during that month Quick Questions Click on pause to give yourself time to answer. A daily dealing fund puts €10,950,000 on deposit on 1st October and receives back principal plus €3,000 interest on 11th October. All other things being equal, consider the effect of interest income on the NAVs in October. Identify the following statements as true or false. The NAV calculated as at close of business on 1st October will increase by €300. This is true. This is the first day of accrual and the fund earns one days interest on this day. From the 1st to the 10th inclusive, the NAV increases by €300 every day. This is true. The fund earns income of €300 every day for 10 days. The cash flow on 11th October does not affect NAV performance. This is true. NAV performance is affected by recognising the income over the period to which it relates not on the date of the cash flow. You should now be able to describe how interest income is recognised by an investment fund, discuss the accruals concept, and calculate interest accruals on cash deposits. When you have completed all 8 QuickTrains in the Introduction to Fund Accounting module, remember to complete the online test. A link to the test is provided at the end of the final QuickTrain.

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QuickTrain 5 – Cash Dividends There are 8 QuickTrains in the Introduction to Fund Accounting module. This is the one fifth one – Cash Dividends. In 8 minutes you will be able to describe what is meant by cash dividends, explain how cash dividends affect the market price of the share and identify when a cash dividend affects the net asset valuation of a fund A cash dividend is a distribution of income by an issuer to its investors. Corporations often pay dividends to their shareholders. Some pay quarterly, some pay semi-annually or annually and some don’t pay at all. In other words, the dividend policy can vary from one issuer to another. The amount of a dividend is variable and is quoted as a cash amount per share. This Apple dividend rate is $3.05. So an investor gets $3.05 for every share held. And these dates here are important. The declaration or announcement date is when the issuer announces details of the upcoming dividend. The ex-date is the date of entitlement: the investor that owns the share on the morning of the ex-date is entitled to the dividend. The ex-date is important from an accounting perspective because it is the date upon which the investor, for example the fund, recognises the dividend income. From a NAV perspective, the first time the dividend income is included in the NAV is the NAV calculated as at close of business on the ex-date or, if there is no NAV calculated for the ex-date, then the first NAV date after the ex-date. The record date is when the issuer’s registrar consults the shareholder records to determine the investors to whom a dividend will be paid. The payment, or cash or due date is when the investor receives the cash. Generally, the difference between ex-date and record date is due to the settlement cycle. For example, in the US, equity trades settle three business days after trade date, T+3. To allow for the fact that the share registrar is updated with trade information on T+3, ex-date is usually two business days before the record date. Look at this Apple dividend. From an accounting perspective there are two key dates, the ex date and the due date. The ex date is when the fund recognises the income and when the NAV is affected. The due date is when the fund actually receives the cash. There are accounting entries associated with the receipt of the dividend but there is no impact on the NAV. If a fund holds 100 Apple shares at the close of business on 8th May and Apple goes ex on 9th May, then the fund is entitled to a dividend of $305. The fund recognises this $305 in the first NAV on or after the ex-date. Assume a daily dealing fund. So the NAV calculated as at close of business on 9th May will include a dividend receivable amount of $305. Does a cash dividend affect the amount of shares held? No. Does a cash dividend affect the share price? Yes. If a share price is $420 and the issuer pays a cash dividend of $3.05 per share, all other things being equal, the share itself should then be worth $416.95. The market price before the dividend, the cum-div price, effectively included the entitlement to the dividend. The market price after the dividend, the ex-div price, means that the buyer at that price is not entitled to the dividend. So the ex-div share price is lower than the cum-div price. How can a valuation be checked for reasonability post-cash dividend? Adjust the prior day price by the dividend to compare like with like. Day before ex-date share price is $420, Close of business on ex-date the price is $397. Price fell by 5.5%. But what about the dividend? Adjust the cum-div price by the $3.05. Compare the $416.95 to the ex-div price of $397. There has been a 4.8% price move on the day. Dividend details can be verified using the DVD or CACS functions on Bloomberg. If withholding tax is shown, the net dividend is the amount that will be received by the fund. Fund accounting should record the gross dividend receivable and the withholding tax payable, even though there is a net receipt. There is an ex-date and then a payment date. The fund creates a dividend receivable on ex-date and so includes the dividend in the nav with effect from the ex-date. So the dividend affect the nav on ex-date; and there is no effect on the NAV the day the cash is actually received. A share price can be expected to fall by the amount of the dividend on ex-date Quick Questions Pause the video if you need additional time to answer questions. A fund calculates NAV daily. It holds 1,000 Microsoft shares. Microsoft declares a dividend of $0.23 per share on 11th May. The ex-date is 14th May, the record date is 16th May and the due date 13th June. Due to a problem at the custodian, the dividend is actually received on 14th June. When does the dividend affect the NAV? The first NAV to include the dividend is the NAV calculated as at the close of business on which of these dates? 11th May, 14th May, 16th May, 13th June, 14th June. And the answer is 14th May, the ex-date. You should now be able to describe what is meant by cash dividends, explain how cash dividends affect the market price of the share and identify when a cash dividend affects the net asset valuation of a fund. When you have completed all 8 QuickTrains in the Introduction to Fund Accounting module, remember to complete the online test. A link to the test is provided at the end of the final QuickTrain.


QuickTrain 6 – Expenses There are 8 QuickTrains in the Introduction to Fund Accounting module. This is the sixth one – Expenses. In 9 minutes you will be able to describe how fixed and variable expenses are calculated and accrued, account for prepaid expenses, and explain how expenses affect the NAV. The costs incurred in operating a fund must be reflected in the NAV. Fund accounting must ensure that all expenses are calculated and allocated to the fund. Remember the accruals concept. Regarding expenses, the fund should allocate expenses to the period to which they relate. So the NAV is affected as the fund recognises expenses, not when the fund pays the bill. Here is a fund with a 31st December year-end. The auditors complete the annual audit for the 2013 accounts in March 2014 and invoice the fund in April. The fund pays the bill, €15,000 in May 2014. This audit fee relates to 2013 and should be recognised in 2013. So at the very beginning of 2013 fund accounting needs to estimate what will the audit fee be for the coming year. The estimate is the basis upon which the fund incurs audit expenses throughout 2013. The fund needs to incur an audit fee expense of €41.10 every day. NAV performance is affected every day by this amount. As the year passes, the balance on the Audit Fee Payable, a liability account, increases to €15,000. When the payment of €15,000 is made, the cash balance decreases and the liability decreases by the same amount. So the payment has no impact on the NAV. That audit fee was an example of what is often called a fixed expense. The amount charged to the fund per day, the €41.10, was based on an estimate of an absolute cash amount. Day to day, the amount does not change. Some other expenses, for example management fees and administration fees, are based on the size of the fund, often based on a % of prior day net assets. As these change daily, these expenses are often called variable expenses. Here is a fund that pays the investment manager a management fee of 1% of net assets. The fund is launched on 1st November with seed capital of €10 million. Let’s consider how this fee is charged and how the NAV is affected throughout the month of November. The management fee in respect of this first day is based on the opening assets of €10 million. At the end of the 1st the fund has incurred an expense of almost €274. And the NAV calculated as at close of business on the 1st should reflect this liability. In respect of the 2nd, the expense is calculated based on the prior day NAV. The NAV calculated at the close of business on the 1st was €10.1 million. So the expense in respect of the 2nd is almost €277. As at the close of business on the 2nd, the fund owes the manager the fee accumulated thus far, €550.68. This is the liability and reflected in the NAV. At every NAV point the management fee is calculated and accrued, that is, added to the liability that the fund owes the investment manager. The management fee expense column shows the management fee charge for the day. The management fee liability column shows the amount the fund owes the investment manager at any point in time. At the end of November the fund owes the manager €8,500. The Investment Management Agreement, between the manager and the fund, states that the manager is paid monthly in arrears on the 15th day after month end. In accordance with this requirement, the fund pays the manager €8,500 on 15th December. So what’s important from an accounting perspective? The key point is this: the NAV is affected every day by the daily management fee expense. The actual cash flow of €8,500 on 15th December does not affect the NAV performance at all. The impact for the €8,500 has been smoothed across the whole month of November. You’ve seen a fixed expense and a variable expense. Both of these were paid in arrears, that is, after the period to which they relate. Some expenses are paid in advance of the period to which they relate, rent for example. A common investment fund expense that is paid in advance is a stock exchange listing fee. This fund will pay the stock exchange in December 2013 in order to be listed on the exchange throughout 2014. Applying the accruals concept, we want there to be no impact on the NAV as a result of the payment in December. We want to charge the fund €5 per day throughout 2014. So when we pay €1,825 we make an accounting entry that creates what is called a Prepaid Expense. This is actually an asset in our NAV calculation. Why? Because it reflects the fact that the Stock Exchange owes the fund a years listing. Our cash decreases by €1,825 and our new asset is created for the same amount. So no impact on the NAV, which is what we want. Throughout 2014 we want to charge the fund €5 per day. So every day, the prepaid expense item of €1,825 reduces by €5 and so reduces the NAV by €5. This is how prepaid expenses are allocated to the period to which they relate. Most fund expenses are calculated and allocated in one of the ways we’ve considered. But there are fees that are based on numbers of transactions or fund performance. And there are fees that are allocated over more than one accounting period. Refer to fund documentation to ascertain the manner in which particular expenses are calculated and allocated. Fixed expenses are charged to the fund based on a cash amount, for example, audit fee, €10,000. Variable expenses are calculated based on the size of the fund, for example, management fee, 2% x prior day total net assets. Most expenses are paid in arrears, that is, after the period to which they relate. Some, however, are prepaid, that is, paid before the period to which they relate. Expenses should affect the NAV during the period to which they relate, not when the payment is made


QuickTrain 6 – Expenses (continued) Quick Questions Click on pause to give yourself time to answer. This fund calculates NAV daily and pays management fee quarterly in arrears. On 1st July the fund receives the Quarter 2 invoice from the investment manager. The fund pays this on 15th July. When does the €21,000 management fee affect the NAV? 1st July, 15th July, 16th July, or none of these? None of these. The effect of the €21,000 would have been reflected in each of the NAVs calculated during Quarter 2. You should now be able to describe how fixed and variable expenses are calculated and accrued, account for prepaid expenses, and explain how expenses affect the NAV. When you have completed all 8 QuickTrains in the Introduction to Fund Accounting module, remember to complete the online test. A link to the test is provided at the end of the final QuickTrain.


QuickTrain 7 – Pricing There are 8 QuickTrains in the Introduction to Fund Accounting module. This is the seventh one – Pricing. In 7 minutes you will be able to describe how an investment fund prices the instruments held in the portfolio and discuss the key elements of a valuation pricing policy. If a fund calculates the NAV on a daily basis then on a daily basis it will mark to market the holdings in the portfolio. That is, it will calculate a market value for the portfolio based on the current market prices of each security in the portfolio. The fund offering documentation, be it the prospectus or the private placement memorandum, will outline, often at a high level, the principles to be followed in applying the valuation policy for the fund. The valuation policy document will provide more detail on the processes involved in calculating market value for the instruments held by the fund. The governing body of a fund, for example the board of directors, is ultimately responsible for what the fund does. Of course, the board will delegate certain functions to the investment manager, to the custodian, to the administrator and so on. So it is likely that different parties will have a role to play in fulfilling the obligations of the fund in meeting the pricing objective. Here are some of the key elements of a pricing policy: First of all what type of market price to use – do you use the last traded price as at the NAV date or do you use the bid price for long positions and the ask or offer price for short positions. Or do you use a mid of the bid and ask? Secondly, from where are these prices sourced? Typically a fund will have a number of data providers. For a given class of instrument it will have a primary source and a secondary source and perhaps a third source. Cross-checks are done between these sources to ensure they are within certain levels of tolerance. Tolerance refers to the amount of divergence between different sources for a given price. Tolerance also refers to the percentage movement of a price over a given period, say, compared to the prior day. For example, a fund accountant or pricing specialist might be required to investigate bond prices moving by more than 1% or equity prices moving by more than 5%. The escalation procedure will outline what needs to be done in cases where tolerances are breached. A stale price policy will outline what is required if a current market price is not available. While actively traded instruments on exchanges can be relatively easily priced there can be challenges in valuing complex instruments, OTC instruments and any illiquid instruments. Also, for a fund of funds, there can be difficulty in ascertaining timely and appropriate valuations in the fund of funds valuation. In these cases it is particularly important to refer to the valuation policy document to ensure that appropriate steps are taken to adhere to the fund pricing policy. A word about financial reporting. The valuation policy as outlined in the valuation policy document prescribes how market values should be calculated for the purposes of the NAV calculation. For financial reporting purposes however, accounting rules determine how market values are calculated. And market value for financial reporting purposes could be different to market value for NAV purposes. A funds pricing policy will determine if the fund uses last traded, bid, mid or ask prices. Funds often receive these prices from independent market data providers. Typical tolerance checks include comparisons of prices from multiple sources. Day-to-day % price changes are also monitored Quick Questions Click on pause to give yourself time to answer. ABC Fund uses Pricing Solutions Limited as a primary pricing source and Securities Data Limited as a secondary source. At one valuation point, for a particular security, Pricing Solutions provides a price of $10.00 and Securities Data provides a price of $9.45. What course of action do you recommend to the fund accountant? Use $10.00, use $9.45, use an average or consult the valuation policy document. Consult the valuation policy document. You should now be able to describe how an investment fund prices the instruments held in the portfolio and discuss the key elements of a valuation pricing policy. When you have completed all 8 QuickTrains in the Introduction to Fund Accounting module, remember to complete the online test. A link to the test is provided at the end of the final QuickTrain.


QuickTrain 8 – NAV There are 8 QuickTrains in the Introduction to Fund Accounting module. This is the eighth one – NAV. In 6 minutes you will be able to calculate a net asset valuation. Having considered different types of fund activity and the pricing process let’s pull it all together in a NAV calculation. Here is a daily dealing fund. It’s a dollar-based fund. The dollar is the accounting and reporting currency and the NAV is calculated in dollars. It is a long only fund that invests in US Equities only and does not use derivatives. We need to calculate the NAV as at the close of business on 30th April. Assets include equities, cash and receivables. The market value of equities is calculated, according to valuation policy, using the last traded price. The changes in prices compared to the prior day are all within tolerance apart from this one. Triple J Inc. The price has gone from $10 to $7.50 in one day. On further investigation the fund accountant establishes that this is a valid price. So here is the total market value of equities for inclusion in the NAV. Here is the cash held by the fund as at close of business on the NAV date. So let’s look at receivables: amounts owed to the fund as at the NAV date. On 29th April the fund did some equity trades that will settle on 2nd May. These trades include sales that total $2,000,000. The fund will receive this amount on 2nd May. We need to include this amount in our assets. The fund issued shares to new investors. These subscriptions, done on 28th April, do not settle until 1st May. The fund will receive the subscription proceeds of $1.5 million on 1st May. We need to include this amount in our assets. Here we have our total assets: equities, cash and receivables. Now let’s list our liabilities. The fund bought equities on 29th and 30th April. These trades will settle on 2nd and 5th May. So as at 30th April the fund owes counterparties amounts totalling $1.25 million. There was a redemption on 29th April. The fund will pay the investor redemption proceeds on 2nd May. The fund accrues management fee, administration fee, custody fee and other expenses. The total expenses payable as at 30th April? $94,500. The calculation of this expenses payable number is not shown here but does conform to the principles covered in the QuickTrain on Expenses. Here we have our total liabilities: payables for purchases, redemptions and expenses. Here is the total net asset value. And the number of shares in issue. The NAV per share. Assets include the market value of securities, cash, amounts receivable for sales, amounts reeivable for subscriptions and income receivable. Liabilities include amounts payable for purchases, amounts payable for redemptions and expenses payable. Assets less liabilities equals total NAV. Total NAV divided by shares in issue equals NAV per share. Quick Questions Click on pause to give yourself time to answer. Based on the following data, what is the NAV per share? Securities 99,000,000 Cash 3,000,000 Receivable for securities sold 1,000,000 Expenses payable 500,000 Payable for securities purchased 1,500,000 Payable for fund shares redeemed 1,000,000 Shares in issue 100,000,000 The NAV per share is $1.0000 You should now be able to calculate a net asset valuation. When you have completed all 8 QuickTrains in the Introduction to Fund Accounting module, remember to complete the online test. A link to the test is provided at the end of this QuickTrain.

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