9.01 A unit investment trust (UIT) is defined by Section 4(2) of the Investment Company Act of 1940 (the 1940 Act) as an investment company organized under a trust indenture, contract of custodianship or agency, or similar instrument. It has no board of directors or trustees, and it issues only redeemable securities, each representing an undivided interest in a unit of specified securities, but does not include a voting trust. Typically, a UIT will make a one-time “public offering” of only a specific, fixed number of units (similar to closed-end funds). Units remain outstanding until a unit holder tenders them to the trustee or sponsor for redemption or until the trust is terminated. The trusts typically have a limited life, ranging from 12 months to 30 years. In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. Trust agreements usually require periodic pro rata distribution to the unit holders of the trust’s entire net investment income and net realized capital gains, if any, and distribution of the proceeds of redemptions, maturities, or sales of securities in the trust, unless the proceeds are used to pay for units to be redeemed. A distinguishing feature of UITs from mutual funds is that the portfolio is intended to be relatively fixed; neither the sponsor nor the trustee has power to manage the portfolio. In general, securities may be sold only for limited purposes (for example, to generate proceeds to pay a redeeming unit holder). Because a UIT does not actively trade its investment portfolio, a UIT generally buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. The portfolio securities held by the UIT are listed in its prospectus. Some exchange-traded funds are structured as UITs.

9.02 Distinguishing Characteristics of UITs. The following table presents distinguishing characteristics of UITs from mutual funds.

9.03 A UIT is one of the three basic kinds of investment companies defined by the 1940 Act. The UIT structure is used primarily as an investment vehicle to hold (a) a portfolio of tax-exempt bonds, corporate bonds, government bonds, and common or preferred stocks or other kinds of securities or (b) the shares of a particular management investment company being accumulated under a contractual plan. (See chapter 10, “Variable Contracts—Insurance Entities,” of this guide for a discussion of UITs as a funding medium for variable annuity contracts.) The form and content of financial statements of UITs are prescribed by Article 6 of Regulation S-X, and Rules 6-10(d) and 12-12 of Regulation S-X prescribe the form and content of financial schedules.

9.04 The discussion in this chapter covers two common types of UITs, fixed-income and equity UITs. The accounting and auditing procedures for UITs are similar to those for other investment companies described in this guide. (See chapter 8, “Other Accounts and Considerations,” of this guide for a discussion of accounting for offering costs of UITs.)

Fixed-Income and Equity UITs

9.05 Units in UITs representing self-liquidating pools of tax-exempt or taxable bonds or other taxable fixed-income securities held in custody by a corporate trustee were first offered to the investing public in the early 1960s. Trusts investing entirely or in part in equity securities became increasingly common in the 1990s.

9.06 The principal objective of most fixed-income UITs is to generate a consistent income stream that may be taxable or tax exempt by investing in a diversified portfolio of securities. The principal objectives of most equity UITs are to generate dividend income and achieve the potential for capital appreciation through investment in a fixed portfolio of stocks.

9.07 A sponsoring organization, such as an investment banking firm or a broker-dealer, initiates a UIT by accumulating a group of securities of a kind specified in the trust indenture. Portfolios may range in fair value from a few million dollars to $100 million or more and may consist of many individual securities. However, equity portfolios are typically seeded with approximately $150,000. Trusts with fixed income portfolios are typically established based on the anticipated number of units to be sold, but they may have additional subsequent deposits. A tax-exempt bond portfolio may be diversified by economic activity (such as education, health care, and housing) or geographic area, or it may be concentrated in a particular state to provide investors with income exempt from federal, state, or local income taxes or any combination thereof. The portfolio may be accumulated by the sponsor over a period ranging from a few days to several weeks or longer. At the deposit date, the portfolio of securities or contracts to purchase securities is conveyed to a corporate trustee at prices defined in the trust agreement. For fixed-income UITs, these prices are usually based on offering prices, rather than bid prices, as determined by an independent evaluator retained by the sponsor. For equity UITs, these prices are usually based on the trustee’s or evaluator’s evaluation of the fair value of the securities in the portfolio as of the deposit date. Cash or an irrevocable letter of credit issued by a commercial bank is delivered to the corporate trustee to cover the cost and accrued interest to settlement dates or expected dates of delivery, if any, of portfolio securities. Securities offered on a when-issued basis, delayed deliveries, or the normal settlement process may cause delayed deposits. An audit of a UIT is usually performed as of the opening of business on the initial date of deposit. As discussed subsequently, annual audits would also be required if the sponsor continues to offer the UITs to the public.

9.08 The sponsoring company, underwriters, and other participants sell units of undivided interest at their public offering price, which is equal to the fair value¹ of the underlying securities owned by the trust plus principal cash, divided by the number of units outstanding plus a sales charge (the “principal net asset value”). The sales charge is a percentage of principal net asset value of the trust unit, and may be reduced on a graduated scale for large purchases. The purchaser of the units also pays the undistributed net income per unit which is the net income (investment income less expense) earned since the previous distribution divided by the number of units outstanding. Upon the formation of the trust, the sponsor may realize a profit or loss on the sale of the underlying securities in the portfolio to the trust equal to the difference between the aggregate cost of the portfolio to the sponsor and the aggregate valuation on the date of deposit. A note to the initial schedule of investments should disclose the aggregate cost of the securities and the related net gain or loss to the sponsor.

9.09 A UIT may be expandable. At the initial date of deposit, a limited amount of securities is placed in the trust, and a limited number of units are issued. However, the trust agreement may provide for expanding the trust in size and number of units through additional deposits of securities in the trust, usually for a period of 90 to 180 days. According to Section 26 of the 1940 Act, any substitution of securities must be approved by the SEC. The auditor may be requested to perform certain agreed-upon procedures at the subsequent deposit dates.

9.10 A UIT generally does not offer units of participation continuously. However, the sponsor may maintain a secondary market by repurchasing units from unit holders at net asset value based on the aggregate bid price of the underlying securities and reoffering them at net asset value based on the aggregate bid or offering prices of the underlying securities plus a sales charge. If the sponsor does not maintain a secondary market or choose to purchase the units, a unit holder can redeem his or her units at net asset value that is usually based on the aggregate bid price of the underlying securities. Some UITs allow unit holders to exchange units of the trust for other kinds of UITs offered by the sponsors, based on relative net asset values, at a reduced sales charge.

9.11 After the initial deposit by the sponsoring entity, all accounting, recordkeeping, and income and principal distribution services are performed by the sponsor or by the trustee. The trustee distributes the accumulated income to unit holders periodically, usually monthly or quarterly, but sometimes semiannually or annually. Usually, as securities are redeemed or mature, the proceeds are distributed to unit holders. Investors may have the option of reinvesting the proceeds from income or principal distributions into additional units of the trust or other investment vehicles of the sponsor.

9.12 The trust generally reports to unit holders periodically on the fair values of the underlying securities and certain other financial information relating to the trust, as generally required by the trust agreement. The valuation policies are similar to those used by other investment companies. Audited financial statements² are usually not distributed to unit holders; however, unaudited calendar year-end distribution information is supplied by the sponsor or trustee. The trust agreement specifies the reporting of tax and other information.

9.13 Some or all of the debt securities owned by certain trusts are covered by insurance obtained by the issuer or trust to guarantee principal and interest payments when due. The treatment of the cost of an insurance policy on an insured portfolio is discussed in chapter 3, “Financial Instruments,” of this guide.

Taxes

9.14 Most UITs elect to qualify as regulated investment companies (RICs) under IRC Subchapter M by complying with the applicable requirements (see chapter 6, “Taxes,” of this guide). They usually distribute all their taxable income and gains from sales of securities and are, therefore, not subject to federal income or excise taxes. Certain UITs may be organized as grantor trusts. The tax requirements for a grantor trust structure are different from a RIC. A grantor trust is formed to facilitate the direct investment of its assets, and ownership of the trust represents undivided beneficial interests in the assets of the trust. If multiple classes of ownership exist, they must be incidental to the purpose of facilitating direct ownership (for example, certain senior or subordinated rights). The trustee does not have the power to vary investments. Unlike a RIC, a grantor trust does not have income and asset qualification tests. Also, the taxable income flows through to the participant as it is earned by the trust, so income recognition to the grantor or beneficiary does not depend on distributions from the trust. UITs structured as grantor trusts pass through principal and interest payments to the grantor or beneficiary, but the cash flows may not fully correlate with the taxable income reported. Under Widely Held Fixed Investment Trust rules, a grantor trust UIT may qualify for simplified reporting on Form 1099 of income, security sales, redemption proceeds, and certain other items. To qualify, at least one interest in the grantor trust UIT must be held by a “middleman” (for example, a custodian, broker, or nominee).³

9.15 If a UIT is a RIC and more than 50 percent of its total assets consist of securities on which interest is exempt from federal income taxes under existing law when received by a trust, the tax-exempt character of the interest is retained when distributed (net of the trust’s expenses) to unit holders. Amounts realized from capital gains and paid to unit holders by the trust are taxable to the unit holder. (Chapter 6 discusses taxes in more detail.)

Illustrative Financial Statements

9.16 The financial statements of UITs are similar to those of management investment companies. When a trust is formed, the financial statements filed with the SEC on Form S-6⁴typically include a statement of assets and liabilities or statement of net assets, schedule of investments, and related notes (see the following illustrative statements). Subsequently, if the sponsor repurchases and reoffers trust units in the secondary market, a posteffective amendment to Form S-6 must be filed during the relevant period with the SEC. The financial statements included in the posteffective amendment, which are prepared in accordance with Regulation S-X, include a statement of condition, a schedule of investments, and statements of operations and changes in net assets (see the following illustrative statements). Audited financial statements are provided to prospective investors in the prospectus. Form S-6 requires that both the statement of operations and statement of changes in net assets cover a three-year period. Financial highlights are required to cover a five-year period.⁵

9.17 Certain disclosures required of registered investment companies for compliance with SEC rules and regulations are not otherwise required by U.S. generally accepted accounting principles. Such compliance disclosures include the following:

a.     The aggregate cost, for federal income tax purposes, of the portfolio of investments according to Rule 6-03(h)(2) of Regulation S-X

b.     The gross unrealized appreciation or depreciation for all securities, on a tax basis, according to Rule 6-03(h)(2) of Regulation S-X

Other requirements identified in Rule 6-10(d) of Regulation S-X, except as otherwise provided in the applicable form, include presentation of the following:

•     A schedule of investments in securities of unaffiliated issuers is required, in accordance with Section 210.12-12, which includes the name of the issuer and the title of issue, the balance held at the close of period, the number of shares—principal amount of bonds and notes, and the value of each item at the close of the period.

•     A schedule showing the amount of trust assets, indicated by each balance sheet filed, which is applicable to each series of trust shares is required if the trust assets are specifically allocated to different series of trust shares, and if such allocation is not shown in the balance sheet in columnar form or by the filing of separate statements for each series of trust shares.

•     A schedule showing the amount of income and distributable funds, indicated by each statement of operations filed, which is applicable to each series of trust shares, is required if the trust income and distributable funds are specifically allocated to different series of trust shares and if such allocation is not shown in the statement of operations in columnar form or by the filing of separate statements for each series of trust shares.

In addition, Rule 6-04.16(b) of Regulation S-X requires UITs to state in a note to the financial statements the total cost to the investors of each class of units or shares, including the adjustment for market depreciation or appreciation, other deductions from the total cost to the investors for fees, loads and other charges (including explanation), and the net amount applicable to the investors.

9.18

Anytown Income Trust
First Intermediate Series
Statement of Assets and Liabilities
August 31, 20X8

Assets

Liabilities and Net Assets

9.19

Schedule 1
Anytown Income Trust
First Intermediate Series
Schedule of Investments
August 31, 20X8

9.20

Anytown Income Trust
First Intermediate Series
Statements of Operations⁶

9.21

Anytown Income Trust
First Intermediate Series
Statements of Changes in Net Assets

9.22

Anytown Income Trust
First Intermediate Series
Notes to Financial Statements

1. Summary of Significant Accounting Policies

Anytown Income Trust (the Trust) was organized on March 23, 20X7, under the laws of the Commonwealth of Massachusetts by a trust indenture and agreement, and is registered as a unit investment trust under the Investment Company Act of 1940. The Trust follows the accounting and reporting guidance in FASB Accounting Standards Codification 946. The significant accounting policies of the Trust include the following:

Basis of presentation. The financial statements are presented on the accrual basis of accounting.

Investments in securities at fair value. Security transactions are recorded on a trade-date basis. Investments in securities owned are carried at fair value, which is determined based on recently executed transactions in securities of the issuer, market price quotations (when observable) or pricing models. The difference between cost and fair value is reflected as unrealized appreciation (depreciation) of investments. Realized gains (losses) from securities transactions are determined for federal income tax and financial reporting purposes on the identified cost basis.

FASB ASC 820-10-35 establishes a hierarchy that prioritizes inputs to fair value measurements. The three levels of inputs are as follows:

•     Level 1. Unadjusted quoted prices in active markets that the Trust has the ability to access for identical assets or liabilities

•     Level 2. Inputs other than quoted prices included in level 1 that are observable for the asset or liability either directly or indirectly. These inputs may include quoted prices for the identical instrument in an inactive market, prices for similar instruments, interest rates, prepayment speeds, credit risk, yield curves, default rates, and similar data.

•     Level 3. Unobservable inputs for the asset or liability to the extent observable inputs are not available, representing the Trust’s own assumptions about the assumptions that a market participant would use in valuing the asset or liability, and that would be based on the best information available.

The following table summarizes the inputs used to value the Trust’s assets and liabilities measured at fair value as of August 31, 20X8.⁷

For movements between Level 1 and Level 2 of the fair value hierarchy, the Trust has adopted a policy of recognizing the transfers at the beginning of period method. There were no transfers between levels during the period.

Income taxes. No provision for federal income taxes has been made in the accompanying financial statements because the Trust has elected to be taxed as a grantor trust under the Internal Revenue Code. The Trust’s net investment income will be taxable as ordinary income to unit holders. Capital gains will be taxable as capital gains to unit holders.

Management has analyzed the Trust’s tax positions and concluded that no liability for unrecognized tax benefits should be recorded related to uncertain tax positions taken on returns filed for 20X7 or expected to be taken in the Trust’s 20X8 tax returns. The Trust is not aware of any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will change materially in the next 12 months. The Trust’s federal tax returns are subject to examination by the Internal Revenue Service for a three year period. There are no examinations in progress at period end.

At August 31, 20X8, the cost of investments on a tax basis was as follows:

There were no differences between book and tax basis cost of investments and net unrealized appreciation (depreciation) at August 31, 20X8.

As of August 31, 20X8, the components of distributable earnings on a tax basis were as follows:

The differences between book and tax basis components of net assets are primarily attributable to appreciation (depreciation) of investments.

Investment expenses. The Trust pays a fee for trustee services to XYZ Bank that is based on $0.75 per $1,000 of outstanding investment principal. In addition, a fixed fee of $35 is paid to a service bureau for portfolio valuation at least weekly and more often at the discretion of the trustee.

Other. Interest income is recognized on an accrual basis. Discounts and premiums on securities purchased are accreted and amortized over the lives of the respective securities.

2. Distributions of Income and Redemption of Units

The Trust agreement requires that the net investment income and net realized capital gains (if any) of the Trust and, also, the proceeds from the sale, redemption, or maturity of securities (to the extent that the proceeds are not used to redeem units) be distributed to unit holders monthly.

The agreement also requires the Trust to redeem units tendered for redemption, to the extent that such units are not purchased by the sponsor, at a price determined based on bid prices of the securities of the Trust.

3. Original Cost to Unit Holders

The original cost to investors⁸represents the aggregate initial offering price as of the date of deposit exclusive of accrued interest. Offering costs include the initial underwriting commission and are charged to paid-in capital on a pro-rata basis as the units are sold by the Trust. The initial underwriting commission and investors’ original cost of units, as shown on the statement of assets and liabilities, are based upon the assumption that the maximum sales commission of 1.5 percent was charged for each initial purchase of units.

4. Investment Transactions⁹

Purchases and sales of investments (excluding in-kind transactions) for the period ended August 31, 20X7 were $14,856,537 and $110,999, respectively.

Purchases and sales of investments (including in-kind redemptions) for the period ended August 31, 20X8 were $0 and $129,000, respectively.

5. Financial Highlights¹⁰