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UNITED STATES PULIC SECURITIES AND EXCHANGE COMMISSION AVAILAILIT il-7 - C) 1 

WASHINGTON. D.C. 20549 

DIVISION OF
 

INVESTMENT MANAGEMENT 

November 7, 1997 

Dear Chief Financial OiTcer: 

The accounting staff of the Division of Investment Management (the "Division") 

has prepared this letter to assist investment company registrants and their independent 

public accountants in dealing with certain accounting-related matters. These comments 

represent the views of the staff of the Division and are not necessarily those of the
 

Securities and Exchange Commission 
 (the "Commission"). The comments described 

below apply to fiings, including reports to shareholders, made by registered investment
 

companies. This letter should be read together with earlier letters issued by the Division's 

Chief Accountant and letters issued by the Division's Office of Insurance Products and 

Offce of Disclosure and Review.
 

Foreign Pricing Considerations
 

In its letter dated November 1, 19961, the staff discussed certain accounting-


related matters involving a fùnds ability to obtain and verify foreign corporate actions. In 

particular, the staff focused on the situation in wltich management of a fund uses 

reasonable diligence to attempt to obtain timely notification and verification of the 

eflective date of foreign corporate actions but delayed the recording of the foreign 

corporate actions until third pai1y confirmation. . Such a procedure is commonly referred 

to as reflecting a "reasonable diligence standard." 

Since the letter' s issuance, registrants have asked whether a reasonable diligence 

standard could extend to the pricing of foreign securities. Although the staff recognizes 

that accounting for both corporate actions and pricing of securities is often intertwined, 

we do not believe the same standard applies. As noted in a previoiis letter2, the 

Commission's Accounting Series Releases 113 and 118 are the accounting standards that 

govern the valuation and accounting for investments.3
 

See Letter 10 Chiel Fiiiancial Oflcers lrom Lcnvreiice A. Friend. dalcd November 1. I tJtJÚ. "Accounting 

ror Foreigii Corporaie Actions." 

See Letter to Chief Fiiiancial Offcers rrom Lawrence A. Frieiid. dated November i. i tJtJ4. "Valuation or 

Certain Portfolio I nvestinents." 

Accounting Series Release ILL. (October 2 L I t)tJ): Accouniing Series Release I I X. (December 23, 

ItJ70). These releases have been codified in Sections 404.04 and 404.(13. respectively. in the 

Codification or Financial Reporting Policies. 
" 

" 

Fund (~tFunds Considerations 

In recent years, the number of fund of funds arrangements,4 in which one fund 

("top tier fùnd") invests its assets in shares of another fund ("underlying fund") rather than 

directly in securities, has increased. In some of these arrangements, the top tier fund has 

invested a significant amount of its investments in an underlying fund. The degree of 

investment raises financial reporting concerns for these top tier funds. Top tier funds, like 

all other funds, report each investment separately on their financial statements.5 When a 

top tier fund has a significant amount of its portfolio invested in a single underlying fund 

or owns a controlling interest in an underlying fund, registrants should consider providing 

additional financial information to shareholders. 

its portfolio invested in 

an underlying fund, the top tier fund should consider accompanying its financial statements 

For example, if the top tier fund has a significant portion of 


with those of the underlying fund. Additionally, if a top tier fund owns a controlling 

interest in 
 an underlying fund, current accounting literature may require consolidating the 

financial statements 'of an underlying fund and the top tier fund6 

Designation of 
 Segregated A.\'sets 

Certain trading practices undertaken by registrants may involve the issuance of 

senior securities subject to the prohibitions and asset coverage requirements of Section 18 

of the Investment Company Act of 1940.7 In 1979, the Commission issued a General 

Statement of PoÜc/ indicating the staffs view that certain instruments held by a fund 

would not be deemed subject to Section 18 if the fund's obligation, with respect to any 

such instrument, was "covered" by assets established and maintained by the fund in a 

segregated account. 

Release 10666 further stated that the board of directors of a fund that is engaged 

in the specified trading practices should review the fùnd' s portfolio and custodial accounts 

to determine if the fund has created or should create any segregated accounts with the 

companv's custodian. Although Release i 0666 includes a section on valuation and 

accQunting, it does not discuss internal accounting control and reporting issues related to 

the segregated accounts. . 

.1 Fund of funds arrangements are sulJject to the provisions of Section 12 of the Investment Company Act 

of I tJ40. 

See Regulation S-X. Ai1icles (i-04. 6-10 and 12-12. 117 CFR 210.6-04.6-10. and 12-12). 

" Statement or Financial Accounting Standards No. 94. "Consolidation of All Majorí~y-Owl1ed
 

.';iihsidiaries. .. financial Accouuting Standards Board. (October. 1987) ("SF AS 94"). SF AS 94 requires 

consolidation of all majority-owned subsidiaries unless control is temporary or does not rest with the 

lIajorily owner. Control is defined as ownership of over 50% of the outstanding voting shares of 

company. While a rund of funds arrangement differs from an operating company envisioned by 

the current accounting literature. SF AS tJ.l suggests that consolidation may be appropriate. 

another 

15 U.S.C XOa-18
 

,/
 

~ hivestmen! Company Act Release No. 10666. April 18. 1979 ("Release 10666"). 

2
 
Typically, investment companies have designated securities to be segregated on the 

records of their custodians. The staff has been asked by registrants whether it would be 

consistent to segregate accounts on the fund's records. The staff has indicated that it 

would not object if assets segregated under Section 18 were designated solely on the 

t-iind's records and not designated on the fund's custodian's records.9 

Accountingfor Securities ¡,em/ing Transactions 

In a typical fund securities lending transaction, the fund lends its securities to a 

borrower which pledges cash or securities as collateral for the securities on loan. 

Generally Accepted Accounting Principles ("GAAP") for securities lending transactions 

are governed by Statement of Financial Accounting Standards No. 125 ("SF AS i 25"). II 

SFAS 12) focuses on "effective control" 11 as a key component for determining the 

accounting treatment for securities on loan and the corresponding collateral exchanged
 

between the lending fund and borrower. 

When a lending fund receives securities as collateral and 
 does not have effective

control over the securities, it should not record the securities as its asset. Conversely,
 

when a fùnd receives securities as collateral and has effective control over the securities, it 

should record the securities as its asset with a corresponding liability for repayment. 

When a t-iind receives cash as collateraL, it is deemed to have effective control of the 

collateral and should record the cash as its asset with a corresponding liability for 1" 

repayment. ~
 

., To ihç e-,tenl that a lìiid designates segregated assels solely on its records. the fund may need to in accordance implement addiiional procedures and controls to ensure thai segregation is undertaken 


\\ith the interprelaiion outlined in Release WCi66.
 

i" ".lcWIiIi/llig .Ii!/ lraiis!á.\" (I/U/ ,"'/'/Ticing ol Fiii(liicial . 
 Isseis and E-rtinguishiients oj' Liahilities, ,. 

Financial Acconniing Siandards Board. (June. 19%) CSFAS 125"). SPAS 125 was amendcd by 

Stalemeiit on Financial Accouniing Siandards No. 127. ''le!áral (/l ihe qli'ctive Dale ol ('crlain 

1'l'wisloll 0(1-: i...¡. ,\101('11/(111 .\"iiiih(' 1';5. .. Financial Accounting Siandards Board. (December. 19(6) 

("SFAS 127") by delcrring the c1Tecti\'e date or certain rcle\'ant portions or SFAS 125. inclnding the 

paragraphs dealing \\'ih securities lending. to Deceiiber ~ I. 1997. For the purpose or this letter. the 

rererclIce \0 SFAS 125 encompasses SF AS 125. as amended by SF AS 127. 

¡¡See SF AS 125. Par. 9 (dcIines the three conditions under which the .transretor has surrcndcrcd control 

O\'er lransrelTed assets. an ol \diich must be met: (i) the transferred asscthas becn put presumptively 

or the transreror and its crcditors. e\'cn in bankniptcy, (2) caeh transfcree may use the 

transrerred assets. and (~) the transreror does not i\(i\.c an agrcement that maintains effective control 

beyoltd the reach 


O\'er the Iransrerred asset.) 

the roiio",ing rcatures:
 See SPAS 125. Par. 27 (defines em:cti\'e control as an agreement that has all of 


--(a) the assets \0 berepurcliased or redeemed are ihe same or subslantially the same as those 

transrerred: (b) the transreror is able to repurchase or redeem them on substantially the agrced terms. 

en:n in the e\'ent or dclÜult by the transferee: (c) the agreement is to repurchase or redecm them berore 

maiuriiy. al a lI-,ed or deteniiinable price: and (d) the agreemeiit is entered concurrently with thc 

I ranslcr.") 

12 See SFAS i 25. Par. i (i i. ..... all cash collaieral should be recorded as an asset by the secured party. 

logcth..1 \\ iih a liahility lor ihe obli~;itioiiio returi it 10 ihe Iraiislcror. \\'hose assel is a rccei\'able."
 

F11i1her. the Ii~!lding lìlld remaiiis Iiahle ror retiiriing ihe amouiil or cash collateraL. and incurs ihe risk
 

or loss from aiiy securiiics purchascd \\"th ihe cash collateraL. .
 

3 
We have noted inconsistent accounting by some funds that automatically reinvest 

cash collateral in securities. These funds are "looking through" to the securities purchased 

with the cash collateral and treating the securities received as collateral without effective 

control. Therefore, the funds do not record them as assets. The staff believes, consistent 

with SF As 125, that a fund has effective control over cash collateral and also has effective 

control over any. securities purchased with the cash collateraL. As a result, a fund should 

record these securities as its asset and a corresponding liability for repayment, in the 13 

amount of the cash collateral received, in its financial statements. 


Closed-End Fund Expense Ratios 

In, reviewing the financial statements of closed-end funds, we have noted 

inconsistencies in how they have calculated their expense ratiosl4 when they incurred 

interest expense on debt securities or paid dividends on preferred shares. 

interest Expense 

Item 4 of Form N-2, flnancial HiKhlighis, requires expense ratios to include all 

expenses of 
 the fund. The instructions to Form N-2 make no exception for any expense 

item; all expenses, including interest expense, should be included in the fund's calculation 

of its expense ratio. 15 

We have been asked by 
 registrants and their independent accountants whether

more than one expense ratio may be shown as a part of 
 the financial highlights table. For

example, some funds believe a more meaningful ratio would be based on expenses that do 

not include interest ("net expenses"). The staff has not objected to a second ratio that 

16 In all cases, the expense ratio that includes
 excludes interest in certain circumstances. 


interest expense ("gross expenses") should 
 be shown in the body of the financial 

highlights. The staff would not object if both the net and gross expense ratios are shown 

in the body of the financial highlights table or if the 
 expense ratio, without the interest 

expense, is reflected in a footnote to the financial highlights table. Both ratios should be 

clearly identified with appropriate disclosure about the differences.

13 The Staff noted in Norwest Bank Minnesota N.A.. SEC No-Action Letter (pub. avaiL. May 15. 1995) 

that cash collateral should be invested in accordance with the funds investment policies. Because the 

fund invests the cash collateral in securities consistent with its policies,. the fund exercises control over 

the cash collateral and the securities purchased with that cash. As fund assets, the securities purchased 

with the cash collateral are subject to the funds usual valuation procedures. 

14 See Form N-2,ltem 4. L line i. 

ì:; In proposing Form N-2. ihe Commission stated that 'interest payments on long-term debt, which may 

be part of the capitalization of a closed-end fund, would be ineluded among the annual shareholder 

expenses." (Release No. LC- i 709 1. July 2X, i 9X9, footnote 18). 

16 This position reflects an application of a general principle stated in the instructions to Form N-2, 

General Instnictions (2) to the form states: "The prospectus or the SAI may contain more inrormation 

than called for by this form, provided the information is not incomplete. inaccurate, or misleading and 

does not, because of its nature, quantity. or manner of presentation. obscure or impede understanding of 

required information." 

4
 
Dividend Payments 

GAA defines preferred stock to be a component of equity and not debt, even 

though it has characteristics of both.17 Accordingly, dividend payments to preferred 

stockholders are not considered to be an expense of the fund and, in the staffs view, 

should not be included as expenses in the financial statements.IS Instruction i 5 to Item 4 

of Form N-2 require~ a fund to "indicate in a note that the expense ratio and net 

investment income ratio do not reflect the effect of dividend payments to preferred 

shareholders." Also, Instruction 9 to Item 3, fee Table and Synopsis, states that other 

expenses includes all expenses that will be reflected as expenses in the registrant's 

statement of operations. Because GAA does not permit dividends to be included as 

expenses in a statement of operations, the staffs position is that dividends would not be 

included as an expense in yither Item 3 or 4 of Form N-2. 

In view of the reporting differences, the staff takes the position that it would not 

object to additional ratios reflecting the treatment of the preferred shares; In the staffs 

view, the additional ratios should not be included on the face of the financial highlights 

table; rather, they should be included in the footnotes to that table. 

Other Disclosures
 

Instruction 6 to Item 3 of Form N-2 prescribes "other expenses (to) be stated as a 

percentage of net asset value attributable to common shares." Although this instruction is 

to Item 3 and is not repeated as an instruction to Item 4, the staff believes the concept
 

should be consistently applied in both tables. Expense ratios should be presented as a 

percentage of the net asset value attributable to common shares only.19 The staff would 

not object to the inclusion, in the footnotes to the financial highlights table, of additional 

ratios that are clearly identifìed and explained. 

The Division acknowledges that its positions stated above with respect to c1osedend fùnds may result in some funds changing their financial statements. To enable those 

funds suffcient time to complete these changes, the staff would not object if registrants 

implement these interpretations for all ratios contained in financial statements for fiscal 

years that begin after November i 5, 1997. 

I' See Accounting Principles Board Opinion Number io - Omnibus Opinion. American Institute or 

Certified Publ ic Accountants_ (Deccmber. 19(6). 

i~ Disiributions 10 prererred and common stockholders are required to be shown broad in Form N-2. 

¡ Item 4.1. ,J 

I') Similarly. the ratio or net income 10 ¿lVerage net assets (Form N-2. Itcll;.l,1 line j.) should 
 also be
 

presented as a perceiltage or the net asset value attributable to common shares si.'JJ~';' 

5 
Organization CO.lt.'ì COn.lÍlerlition.'ì 

The stafl continues to address questions from registrants and their independent
 

accountants regarding the accounting treatment for organization costs20 that arise in 

connection with a merger, liquidation, or dissolution of a fund.21 The staff has indicated 

that the remaining amount of organization costs, in such a transaction, are the 

responsibility of the holder of the original shares and should be netted against redemption 

proceeds of the original shares.22 The staff has indicated that it is not appropriate to 

accelerate the write-off of the remaining organization costs to the date of the merger, 

liquidation, or dissolution, or to immediately charge to fund expenses the remaining 

amount of organization costs. 

************** 

This letter c~ntains information of importance to the company's independent 

public accountants;' therefore, we encourage you to discuss these items with them. 

Address any questions about the contents of this letter or related matters to John S. 

Capone or Paul T. Kraft, Assistant Chief Accountants, or me, at (202) 942-0590. 

Very truly yours, 

~)/i~~~ !2. l~.,l 

Lawrence A. Friend 

Chief Accountant 

~(l This ilem docs not addrcss any possible changes to the accounting ror and the reporting on 

organization costs as coniemplated in proposed Statemenl or Position (SOP) "Reporting on Costs or 

Start-Up Acii\'iiies:' daled April 22. 1997. issued by ihc American Institulc or Certified Public 

Accountants. 

The starr would not object if. in the case or a merger. the organizcÙion costs or thc acquiring. 

Icgal suniHlr rund are capitalized and amortized. Howeyer. rcmaining organization costs of the target ) 

rUiidshouldbe nCllcd against thc redemption proceeds of the original shares. 

Sec Lettcr to ¡Ü:gisir,.iiis ¡ruii' c'arolyn B. Lewis. dated January 3. I 9tJ 1. Item II. E. 

"Organization Expcnses."
 

6' 

21