Recordkeeping Requirements

2.04 The Investment Company Act of 1940 (the 1940 Act) prescribes minimum accounting records for registered investment companies.¹ Section 31 of the 1940 Act and rules under that section require investment records for all registered investment companies to include the following:

•     Journals or other records of original entry that show all securities purchases and sales, receipts and deliveries of securities, and collections and payments of cash for securities transactions

•     A securities record or ledger showing the unit, quantity, price, and aggregate cost separately for each portfolio item and transaction as of the trade date

•     A record for each portfolio item of all trading orders for purchase, sale, sell short or cover short by, or on behalf of, the investment company and the action on each order

The books and records of registered investment companies are subject to the retention and inspection requirements set forth in rules under the 1940 Act.²

2.05 If any records required by the rules are maintained by an agent, such as a custodian or transfer agent, the registered investment company should obtain the agent’s written agreement to make the records available on request and to preserve them for the required periods.

Custody of Securities

2.06 An investment company’s securities are usually held in the custody of a bank, which, for registered investment companies, must have prescribed minimum aggregate capital, surplus, and undivided profits.³ A member firm of a national securities exchange or a central securities system registered with the SEC also may serve as custodian. To use a member of a national securities exchange as custodian, a registered investment company must initially obtain the approval of a majority of its board of directors or trustees. The 1940 Act and the related rules require that securities held in custody by a member of a national securities exchange be inspected at various times by the registered investment company’s auditor and that the auditor issue a report thereon to the SEC.⁴ Investment companies may also enter into subcustodial agreements, usually to provide a local custody function for investment in foreign securities. The nature of these agreements can vary regarding whether the principal custodian does or does not assume responsibility for the subcustodian’s actions. (See also the discussion in paragraph 2.184 relating to foreign custodian arrangements and in paragraphs 11.29–.32 and paragraphs 11.35–.39 relating to the auditor’s procedures with respect to custodians.)

2.07 Registered investment companies are required to file copies of their custodial agreements with the SEC. Significant provisions of such agreements deal with the following:

•     Physical and book segregation of securities in custody

•     Denying custodians the power to assign, hypothecate, pledge, or otherwise encumber or dispose of any securities except in acting at the direction and for the account of the registered investment company

•     Immunity of such securities to liens asserted by a custodian

•     The right of the SEC and the company’s independent auditor to inspect the securities at any time⁵

2.08 An investment company may retain custody of its securities by depositing them for safekeeping in a vault or other depository maintained by a bank or company whose functions and physical facilities are supervised by federal or state authorities. The 1940 Act and the related rules require all securities determined to be held in safekeeping, either by a registered investment company or an affiliated bank as a custodian, to be inspected at various times by the registered investment company’s independent auditor.⁶ The deposited securities are required to be physically segregated and are subject to withdrawal only by duly authorized persons under specified conditions.

Accounting for Segregated Accounts

2.09 Certain investment transactions may involve a registered investment company’s issuance of a senior security, as defined under Section 18 of the 1940 Act.⁷ Section 18 also contains restrictions on the issuance of senior securities. Generally, a senior security represents an indebtedness of the investment company (for example, leverage), including certain transactions under which the investment company enters into a contractual purchase or delivery obligation (for example, futures and written options on securities). The SEC does not raise the issue of compliance with Section 18 with respect to certain transactions if a registered investment company designates certain assets in a segregated account, either with the custodian or in its accounting records, as “cover” for indebtedness. Such assets consist of cash or securities, as permitted by the SEC (that is, that meet the liquidity guidelines specified by the SEC), and they may be replaced only by other similar assets.⁸ According to SEC Release No. 10666 under the 1940 Act, securities maintained in such segregated accounts should be valued using an appropriate methodology for those securities. The determination of whether a senior security has been issued or adequately covered is, at times, complex and may require the involvement of legal counsel.⁹

2.10 An investment company using a bank or member of a national securities exchange as custodian of its securities may agree to have qualifying securities deposited in a clearing agency, such as a central securities system, that is registered with the SEC. Clearing agencies use the book entry shares method of accounting for securities transfers rather than methods based on the physical movement of the securities. Most investment companies’ portfolio securities that qualify are now held by clearing agencies (for example, The Depository Trust Company) through arrangements with the investment companies’ custodians instead of being held by the custodians in a physically issued form. Investment companies or their custodians may also use the Federal Reserve’s book entry system as a depository for U.S. and federal agency securities. Special rules apply to the use of central securities systems and book entry systems.¹⁰

2.11 If a registered investment company uses a bank as custodian for its securities, the proceeds from sales of such securities and other cash assets, except for minor amounts in checking or petty cash accounts approved by the board of directors or trustees, are required to be kept in the bank’s custody.¹¹ SEC regulations also permit the maintenance of cash balances with futures commission merchants solely for the purpose of clearing daily activity in futures contracts and related options.¹²

Routine Investment Procedures

2.12 Although the overall direction of the investment activities of an investment company is the responsibility of its board of directors or trustees or general partner, the board typically delegates the routine operating and investment decisions to an investment committee; a portfolio manager; or, as occurs in most situations, an investment adviser. Investment decisions are communicated by the investment company’s adviser or the adviser’s employees who place orders with brokers. An investment company’s registration statement or offering circular indicates its policies on selecting brokers and using affiliates to execute trades. A well-designed system of controls for investment transactions generally should include the procedures described in the following paragraphs.

2.13 A registered investment company is required by Rule 31a-1 of the 1940 Act to document, among other things, the placement of a securities order in an internal record that shows the person who authorized and placed the order, the security, the number of shares or the principal amount ordered, the price or price range, the date and time that the order was entered and executed, the commission rate or amount (or other compensation paid), the broker selected, and the reason for the selection. Executed transactions are routinely confirmed electronically or by telephone, and confirmations are followed by electronic or written advices containing all information pertinent to the trades. The advices for money market instruments ordered through a bank often consist of bank debit or credit memorandums.

2.14 An investment company generally should notify the custodian promptly of each securities transaction and issue detailed instructions to receive or deliver securities and collect or disburse cash. Those instructions ordinarily should include the name of the broker, the description and quantity of the security, the trade and settlement dates, and the net amount of cash to be collected or disbursed. New York Stock Exchange (NYSE) Rule 387 requires the electronic depository confirmation-affirmation system (also known as Broker ID System) to be used to effect securities transactions on a cash-on-delivery or delivery-versus-payment (DVP) basis. The instructions ordinarily should be signed by one or more authorized representatives of the investment company whose signatures are on file with the custodian; if instructions are given by telephone or electronically, procedures should be established to provide for proper authorization.

2.15 As advices confirming trades are received, they should be reviewed promptly for conformity of terms; clerical accuracy; and proper application of commission rates, including volume discounts or negotiated rates, as applicable, and should be compared with the internal records established when the orders were placed.

2.16 Investment companies almost always require receipt of cash for securities delivered by the custodian to settle sales of portfolio investments. Similarly, the custodian pays on a DVP basis. In certain countries, however, there is no DVP standard. Unless otherwise instructed, the custodian rejects a transaction if either the number of shares or settlement amount determined by the broker does not agree exactly with the written instructions previously authorized by the investment company.

2.17 The custodian notifies the investment company promptly of cash settlements and receipts or deliveries of securities. Settlement dates vary based on the kind of security traded, from same-day settlement to four weeks or more. On receipt of such notifications, the investment company ordinarily should compare them against its records to identify discrepancies. Fails to receive or fails to deliver generally should be identified on the settlement date and followed up promptly.

2.18 The custodian issues periodic statements listing all receipts and deliveries of securities and related collections and disbursements of cash. Securities on hand and the cash balance at the end of the period may also be provided. An investment company generally should reconcile promptly the custodian’s statements with its books and records and ordinarily should initiate timely follow-up procedures on reconciling items. The investment company generally should be satisfied with the adequacy of the custodian’s procedures and controls that relate to functions carried out on its behalf, especially procedures and controls for receipt, delivery, and safekeeping of securities.

Net Asset Value Per Share

2.19 Virtually all open-end registered investment companies and many closed-end registered investment companies prepare daily price make-up sheets computing net asset value per share each day that the NYSE conducts trading activity. The FASB ASC glossary defines net asset value per share as the amount of net assets attributable to each share of capital stock (other than senior equity securities; that is, preferred stock) outstanding at the close of the period. It excludes the effects of assuming conversion of outstanding convertible securities, regardless of whether their conversion would have a diluting effect. Rule 22c-1(b) of the 1940 Act establishes customary U.S. business days as the days on which an open-end investment company, at a minimum, must price its redeemable securities, provided that customer orders have been received, and significant price changes in the fund’s portfolio securities or other activities or transactions affecting the per share net asset value of the fund exist. Closed-end registered investment companies may compute net asset value per share less frequently, such as weekly or semimonthly.

2.20 Net asset values per share should reflect portfolio securities at fair value, as defined in FASB ASC 946-10-20 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Securities should be valued at least as often as net asset value per share is computed or shares are issued or redeemed. Registered investment companies value their portfolios at such time of day and at such frequency as is determined by their boards of directors or trustees or the general partner.¹³

2.21 Rule 2a-4(a) of the 1940 Act requires that changes in security positions be reflected in the net asset value per share computations no later than the first calculation following the trade date.¹⁴ Similarly, changes in the number of the investment company’s outstanding shares from sales, distributions, and repurchases should be reflected in the computations no later than the first calculation following such changes.

2.22 Because of the importance of net asset value per share, many investment companies perform additional procedures to determine the accuracy of security valuations. The fair value assigned to each security position may be compared with the fair value used on the preceding valuation date to detect increases or decreases in specific security values that are unusual or that exceed predetermined thresholds for change in fair value amounts or percentages. In addition, unchanged security values may be reviewed to determine whether the valuation continues to be appropriate. It is advisable to review and explain unusual increases, decreases, or unchanged prices. See the “Valuing Investments” section of this chapter for further discussion of valuation controls and methodologies.

2.23 Net asset value per share should also reflect expenses, interest, dividends, and other income through the date of the calculation.¹⁵ The 1940 Act does not require expenses, income items, or both to be accrued daily if their net cumulative amount is less than one cent per outstanding share.¹⁶ Other aspects of accrual accounting specific to investment companies, discussed in this chapter and other chapters of the guide, could also be considered.

2.24 Mutual funds with multiple classes of stock must determine the net assets and net asset value per share for each class in accordance with the procedures enumerated by Rule 18f-3 of the 1940 Act (or in accordance with an exemptive order issued by the SEC). See chapter 5, “Complex Capital Structures,” of this guide for additional information on multiple-class funds.

Basis of Recording Securities Transactions

2.25 FASB ASC 946-320-25-1 states that an investment company should record security purchases and sales as of the trade date.

2.26 Because securities transactions are recorded as of the trade date rather than the settlement date, the statement of assets and liabilities of most investment companies at the end of an accounting period includes receivables from brokers for securities sold but not delivered and payables to brokers for securities purchased but not received.

2.27 As noted in FASB ASC 946-320-25-2, a securities transaction outside conventional channels, such as through a private placement or by submitting shares in a tender offer, should be recorded as of the date that the investment company obtained a right to demand the securities purchased or to collect the proceeds of sale and incurred an obligation to pay the price of the securities purchased or to deliver the securities sold, respectively. Determining the recording date may sometimes require an interpretation by legal counsel.

2.28 This topic of a securities transaction occurring outside of conventional channels is also discussed in Section 404.03.a of the SEC’s Codification of Financial Reporting Policies.

2.29 FASB ASC 946-320-30-1 states that an investment company should initially measure its investments in debt and equity securities at their transaction price. The transaction price should include commissions and other charges that are part of the purchase transaction.

2.30 FASB ASC 860, Transfers and Servicing, provides accounting and reporting standards that are applicable to certain investment companies’ transactions, such as repurchase and reverse repurchase agreements, dollar rolls, and securities borrowed and loaned. See paragraphs 2.140–.141 for further discussion of the accounting and reporting standards associated with such transactions.

Valuing Investments

2.31 Values and changes in values of investments held by investment companies are as important to investors as the investment income earned thereon. Pursuant to FASB ASC 946-320-35, FASB ASC 946-323, FASB ASC 946-325-35, FASB ASC 946-810, and FASB ASC 815-10-35, investment companies are required to measure subsequently and report their investment assets (for example, debt and equity securities and derivatives) at fair value (as previously defined). As discussed in FASB ASC 820-10-35-41, a quoted price in an active market provides the most reliable evidence of the fair value and should be used without adjustment to measure fair value whenever available, except as specified in paragraph 41C of FASB ASC 820-10-35. An active market is defined by the FASB ASC glossary as a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

2.32 Registered investment companies are also governed by the definition of value found in Section 2(a)(41) of the 1940 Act and further interpreted in Section 404.03 of the SEC’s Codification of Financial Reporting Policies. With respect to securities for which market quotations are readily available, Section 2(a)(41) states that value is defined as the market (fair) value of such securities determined by reference to market information. With respect to other securities and assets, Section 2(a)(41) states that value is defined as the fair value determined in good faith by the board of directors. This is also described in Accounting Series Release No. 118.¹⁷

2.33 Many financial instruments are traded publicly in active markets; therefore, end-of-day market quotations are readily available. However, if quoted market prices in active markets are not available, fair value may be estimated in a variety of ways, depending on the nature of the instrument and the manner in which it is traded.¹⁸ Management’s best estimate in good faith (under the oversight of the board of directors or trustees) of fair value should be based on the consistent application of a variety of factors, in accordance with the valuation policy followed by the fund, with the objective being to determine the exit price or amount at which the investment could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The fair value reported for investments is not reduced by transaction costs such as estimated brokerage commissions and other costs that would be incurred in selling the investments. As noted in FASB ASC 820-10-35-2B, the fair value measurement of a particular asset or liability should consider the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following: (a) the condition and location of the asset, and (b) restrictions, if any, on the sale or use of the asset. A restriction that would transfer with the asset in an assumed sale would generally be deemed a characteristic of the asset and therefore would likely be considered by market participants in pricing the asset. Conversely, a restriction that is specific to the reporting entity holding the asset would not transfer with the asset in an assumed sale and therefore would not be considered when measuring fair value.

2.34 FASB ASC 820-10-35 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3). FASB ASC 820, Fair Value Measurement also clarifies that fair value is market based, as opposed to an entity-specific measure.

2.35 An investment company’s registration statement or offering circular describes the methods used to value its investments.¹⁹ Section 404.03 of the SEC’s Codification of Financial Reporting Policies describes various methods for estimating fair value.

2.36 As discussed in paragraphs 2–3 of FASB ASC 946-320-35, valuing securities listed and traded on one or more securities exchanges or unlisted securities traded regularly in over-the-counter (OTC) markets (for example, U.S. Treasury bonds, notes, and bills or stocks traded in the NASDAQ Stock Market) ordinarily is not difficult because quotations of completed transactions are published daily, or price quotations are readily obtainable from financial reporting services or individual broker-dealers. A security traded in an active market on the valuation date is valued at the last quoted sales price. (See also the discussion starting at paragraph 11.55.)

2.37 FASB ASC 820-10-35-6C provides that even when there is no observable market to provide pricing information about the sale of an asset or the transfer of a liability at the measurement date, a fair value measurement should assume that a transaction takes place at that date, considered from the perspective of a market participant that holds the asset or owes the liability. Consistent with FASB ASC 820-10-30-2, the objective of a fair value measurement focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability in an exchange transaction (an entry price). However, FASB ASC 820-10-30-3 explains that, in many cases, the transaction price will equal fair value (for example, that might be the case when, on the transaction date, the transaction to buy an asset takes place in the market in which the asset would be sold).

2.38 Paragraphs 5–6 of FASB ASC 820-10-35 states that the transaction to sell the asset or transfer the liability takes place in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. As defined by the FASB ASC glossary, the principal market is the market with the greatest volume and level of activity for the asset or liability. Also, as defined by the FASB ASC glossary, the most advantageous market is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs. A reporting entity need not undertake an exhaustive search of all possible markets to identify the principal market or the most advantageous market, but it should take into account all information that is reasonably available. If there is a principal market for the asset or liability, the fair value measurement should represent the price in that market (whether that price is directly observable or estimated using another valuation technique), even if the price in a different market is potentially more advantageous at the measurement date. The reporting entity must have access to the principal (or most advantageous) market at the measurement date. Because different entities (and businesses within those entities) with different activities may have access to different markets, the principal (or most advantageous) market for the same asset or liability might be different for different entities (and businesses within those entities). Therefore, the principal (or most advantageous) market (and thus, market participants) should be considered from the perspective of the reporting entity, thereby allowing for differences between and among entities with different activities.

2.39 Investment companies may find guidance in the preceding paragraphs useful when investment portfolios include securities listed on (a) more than one national securities exchange, or (b) on a national exchange and in the OTC market. When applying guidance in the preceding paragraphs to these scenarios, the exchange or market that contains the greatest volume and level of activity for that security would likely be deemed the principal market. When an investment company holds a security that is not traded in the principal market on the valuation date, the security may be valued at the last quoted sales price on the next most active market if management determines that price to be representative of fair value. If the price is determined not to be representative of fair value, the security may be valued based on quotations readily available from principal-to-principal markets, financial publications, or recognized pricing services, or a good-faith estimate of fair value should be made.

2.40 As explained in FASB ASC 820-10-35-9B, the price in the principal (or most advantageous) market used to measure the fair value of the asset or liability should not be adjusted for transaction costs, which should be accounted for in accordance with the provisions of other accounting guidance. As defined by the FASB ASC glossary, transaction costs are the costs to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability that are directly attributable to the disposal of the asset or the transfer of the liability. Transaction costs meet both of the following criteria:

a.     They result directly from and are essential to that transaction.

b.     They would not have been incurred by the entity had the decision to sell the asset or transfer the liability not been made (similar to costs to sell, as defined by FASB ASC 360-10-35-38).

2.41 Securities markets, financial publications, and recognized pricing services frequently provide quotations of bid price and asked price. Those quotations may be used if a principal-to-principal market is the primary market for the security on the valuation date or, in the absence of trading, on the valuation date of the security normally traded primarily on an exchange. Some investment companies use the bid price to value securities, some use the mean between the bid and asked prices, and some use a valuation within the range between the bid and asked prices that is considered to best represent fair value in the circumstances. If price quotations are obtained from individual broker-dealers making a market in the security, some investment companies will estimate fair value as the mean of the quoted prices obtained. Each of those policies is acceptable if applied consistently and in accordance with the investment company’s established pricing policy. However, neither use of the asked price alone to value investments nor use of the bid price alone to value short sales or short positions is acceptable. If only a bid price or an asked price is available for a security on the valuation date, or the spread between the bid and asked price on that date is substantial, quotations for several days could be, for example, reviewed in determining whether the last quoted price is representative of fair value.

2.42 Many funds utilize pricing services to obtain security valuations. Those pricing services may provide quotations on listed securities and OTC securities, as described in the preceding paragraphs. Also, particularly for debt securities, pricing services may provide valuations determined by other pricing techniques. Methods generally recognized in the valuation of financial instruments include comparison to reliable quotations of similar financial instruments, pricing models, matrix pricing, or other formula-based pricing methods. Those methodologies incorporate factors for which published market data may be available. For instance, the mathematical technique known as matrix pricing may be used to determine fair value based on market data available with respect to the issue and similar issues without exclusive reliance on issuer-specific quoted market prices.

2.43 The incorporation of a premium or discount in the fair value measurement is discussed in FASB ASC 820-10-35-36B:

A reporting entity shall select inputs that are consistent with the characteristics of the asset or liability that market participants would take into account in a transaction for the asset or liability (see paragraphs 2B-2C of FASB ASC 820-10-35). In some cases, those characteristics result in the application of an adjustment, such as a premium or discount (for example, a control premium or noncontrolling interest discount). However, a fair value measurement shall not incorporate a premium or discount that is inconsistent with the unit of account in the FASB ASC topic that requires or permits the fair value measurement. Premiums or discounts that reflect size as a characteristic of the reporting entity’s holding (specifically, a blockage factor that adjusts the quoted price of an asset or a liability because the market’s normal daily trading volume is not sufficient to absorb the quantity held by the entity, as described in FASB ASC 820-10-35-44) rather than as a characteristic of the asset or liability (for example, a control premium when measuring the fair value of a controlling interest) are not permitted in a fair value measurement. In all cases, if there is a quoted price in an active market (that is, a level 1 input) for an asset or a liability, a reporting entity shall use that quoted price without adjustment when measuring fair value, except as specified in FASB ASC 820-10-35-41C.

2.44 To summarize, the unit of account of the asset or liability is the primary determining factor when deciding to include or exclude a premium or discount during fair value measurement. The unit of account is determined through applicable U.S. generally accepted accounting principles in the respective FASB ASC topic that permitted or required fair value measurement of the asset or liability (for example, reporting units in FASB ASC 350, Intangibles—Goodwill and Other).

•     When a discount or premium is a characteristic of the asset or liability (the unit of account), it can be incorporated in the fair value measurement. For example, a premium associated with a controlling equity interest in an investee would be incorporated into the fair value measurement. Sale restrictions and market liquidity may be other asset or liability characteristics that generate premiums or discounts and should be incorporated into the fair value measurement.

•     When a discount or premium is a characteristic of the entity’s holding in an asset or liability with a unit of account, it cannot be incorporated in the fair value measurement. For example, a discount associated with a blockage factor (a factor that adjusts the quoted price of an asset or a liability because the market’s normal daily trading volume is not sufficient to absorb the quantity held by the entity) would not be incorporated into the fair value measurement.

Fair Value Determination When the Volume or Level of Activity Has Significantly Decreased

2.45 Situations may arise when quoted market prices are not readily available or when market quotations are available, but it is questionable whether they represent fair value. Examples include the following instances:

•     Market quotations and transactions are infrequent, and the most recent quotations and transactions occurred substantially prior to the valuation date.

•     The market for the security is “thin” (that is, there are few transactions or market-makers in the security, the spread between the bid and asked prices is large, and price quotations vary substantially either over time or among individual market-makers).

•     The last quoted market prices for foreign securities are as of the close of a market that precedes the fund’s normal time for valuation, and certain events have taken place since the close of that foreign market that provide evidence that the market prices of those securities would be substantially different at the fund’s normal time for valuation if such foreign market were open at that time. Such events are referred to by the SEC staff as significant events.²⁰

•     Trading in a market or for a specific security had been suspended during a trading day and had not reopened by the fund’s normal time for valuation for such reasons as the declaration of a market emergency by a regulatory body, the imposition of daily price change limits or “circuit-breakers,” or the intended release of information by an issuer was expected to have a material effect on a security’s value.

Similar circumstances may also affect the appropriateness of valuations supplied by pricing services. Situations such as the preceding are expected to be rare but may occur. In those cases, an investment company may establish a policy to substitute a good-faith estimate of fair value for the quoted market price or pricing service valuation. Any policy adopted should be consistently applied in all situations when significant pricing differences are determined to exist.

2.46 Paragraphs 54C–54M of FASB ASC 820-10-35 clarify the application of FASB ASC 820 in determining fair value when the volume and level of activity for an asset or liability has significantly decreased. Guidance is also included in identifying transactions that are not orderly. In addition, paragraphs 90–98 of FASB ASC 820-10-55 include illustrations on the application of this guidance.

2.47 The definition of fair value states that it is the price obtained in an orderly transaction. The FASB ASC glossary defines an orderly transaction as a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).

2.48 Consistent with FASB ASC 820-10-35-54G, even when there has been a significant decrease in the volume or level of activity for the asset or liability, the objective of a fair value measurement remains the same. A reporting entity should evaluate the significance and relevance of the factors listed in FASB ASC 820-10-35-54C to determine whether, on the basis of the evidence available, there has been a significant decrease in the volume or level of activity. According to FASB ASC 820-10-35-54D, if, after evaluating the factors, the conclusion is reached that there has been a significant decrease in the volume or level of activity for the asset or liability in relation to normal market conditions, further analysis of the transactions or quoted prices is needed. A decrease in the volume or level of activity on its own may not indicate that a transaction price or quoted price does not represent fair value or that a transaction in that market is not orderly. However, if a reporting entity determines that a transaction or quoted price does not represent fair value (for example, there may be transactions that are not orderly), an adjustment to the transactions or quoted prices will be necessary if the reporting entity uses those prices as a basis for measuring fair value and that adjustment may be significant to the fair value measurement in its entirety. Adjustments may also be necessary in other circumstances (for example, when a price for a similar asset requires significant adjustment to make it comparable to the asset being measured or when the price is stale). According to FASB ASC 820-10-35-54F, the objective is to determine the point within the range of fair value measurements that is most representative of fair value under the current market conditions. A wide range of fair value measurements may be an indication that further analysis is needed.

2.49 FASB ASC 820-10-35-54H states that estimating the price at which market participants would be willing to enter into a transaction at the measurement date under current market conditions if there has been a significant decrease in the volume or level of activity for the asset or liability depends on the facts and circumstances at the measurement date and requires judgment. A reporting entity’s intention to hold the asset or to settle or otherwise fulfill the liability is not relevant, however, because fair value is a market-based measurement, not an entity-specific measurement.

2.50 According to FASB ASC 820-10-35-54I, a reporting entity should evaluate the circumstances to determine whether, based on the weight of the evidence available, the transaction is orderly. When there has been a significant decrease in the volume or level of activity for the asset or liability, it is not appropriate to conclude that all transactions are not orderly (that is, distressed or forced). Circumstances that may indicate that a transaction is not orderly include the following:

•     There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions.

•     There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant.

•     The seller is in or near bankruptcy or receivership (that is, the seller is distressed).

•     The seller was required to sell to meet regulatory or legal requirements (that is, the seller was forced).

•     The transaction price is an outlier when compared with other recent transactions for the same or a similar asset or liability.

The determination of whether a transaction is orderly or is not orderly is more difficult if there has been a significant decrease in the volume or level of activity for the asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities).

2.51 FASB ASC 820-10-35-54J states that a reporting entity should consider all of the following when measuring fair value or estimating market risk premiums:

•     If the evidence indicates that the transaction is not orderly, a reporting entity should place little, if any, weight (compared with other indications of fair value) on that transaction price.

•     If the evidence indicates that a transaction is orderly, a reporting entity should take into account that transaction price. The amount of weight placed on that transaction price when compared with other indications of fair value will depend on the facts and circumstances, such as the volume of the transaction, the comparability of the transaction to the asset or liability being measured, and the proximity of the transaction to the measurement date.

•     If a reporting entity does not have sufficient information to conclude whether a transaction is orderly, it should take into account the transaction price. However, that transaction price may not represent fair value (that is, the transaction price is not necessarily the sole or primary basis for measuring fair value or estimating market risk premiums). When a reporting entity does not have sufficient information to conclude whether particular transactions are orderly, the reporting entity should place less weight on those transactions when compared with other transactions that are known to be orderly.

In making the determination regarding whether a transaction is orderly, a reporting entity does not need to undertake exhaustive efforts, but should not ignore information that is reasonably available. When a reporting entity is a party to a transaction, it is presumed to have sufficient information to conclude whether the transaction is orderly.

Valuation Techniques

2.52 Rule 38a-1 under the 1940 Act requires registered investment companies and business development companies (BDCs) (referred to in the adopting release as funds) to adopt policies and procedures reasonably designed to prevent the violation of federal securities laws.²¹ In the adopting release, the SEC stated that Rule 38a-1

requires funds to adopt policies and procedures that require the fund to monitor for circumstances that may necessitate the use of fair value prices; establish criteria for determining when market quotations are no longer reliable for a particular portfolio security; provide a methodology or methodologies by which the fund determines the current fair value of the portfolio security; and regularly review the appropriateness and accuracy of the method used in valuing securities, and make any necessary adjustments. [footnotes omitted]²²

Investment companies offering their shares on Forms N-1A and N-3 are also required by the SEC to provide a brief explanation in their prospectuses of the circumstances under which they will use fair value prices and the effects of using fair value pricing.²³

2.53 The SEC’s Codification of Financial Reporting Policies provides guidance on the factors to be considered in, and the responsibilities for and methods used for, the valuation of securities for which market quotations are not readily available.²⁴ The following paragraphs regarding securities valued in good faith are consistent with those SEC policies and are intended to summarize and provide guidance on this topic.

2.54 The objective of the fair value estimation process is to state the securities at the amount at which they could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The term current transaction means realization in an orderly disposition over a reasonable period. All relevant factors generally should be considered in selecting the method of estimating in good faith the fair value of each kind of security.

2.55 In estimating in good faith the fair value of a particular financial instrument, the board or its designee (the valuation committee) generally should, to the extent necessary, take into consideration all indications of fair value that are available. This guide does not purport to delineate all factors that may be considered; however, the following is a list of some of the factors to be considered:

•     Financial standing of the issuer

•     Business and financial plan of the issuer and comparison of actual results with the plan

•     Cost at the date of purchase

•     Size of the position held and the liquidity of the market²⁵

•     Security-specific contractual restrictions on the disposition

•     Pending public offering with respect to the financial instrument

•     Pending reorganization activity affecting the financial instrument (such as merger proposals, tender offers, debt restructurings, and conversions)

•     Reported prices and the extent of public trading in similar financial instruments of the issuer or comparable entities

•     Ability of the issuer to obtain the needed financing

•     Changes in the economic conditions affecting the issuer

•     A recent purchase or sale of a security of the entity

•     Pricing by other dealers in similar securities

•     Financial statements of the investees

2.56 No single method exists for estimating fair value in good faith because fair value depends on the facts and circumstances of each individual case. Valuation methods may be based on a multiple of earnings or a discount or premium from a market of a similar, freely traded security of the same issuer; on a yield to maturity with respect to debt issues; or on a combination of these and other methods. In addition, with respect to derivative products, other factors (such as volatility, interest and foreign exchange rates, and term to maturity) should be considered. The board of directors or trustees should be satisfied, however, that the method used to estimate fair value in good faith is reasonable and appropriate and that the resulting valuation is representative of fair value.

2.57 According to Sections 404.03–.04 of the SEC’s Codification of Financial Reporting Policies, the information considered and the basis for the valuation decision should be documented, and the supporting data should be retained. The board may appoint individuals to assist it in the estimation process and to make the necessary calculations. The rationale for the use of a good-faith estimate of fair value that is different from market quotations or pricing service valuations ordinarily should be documented. If material, the circumstances surrounding the substitution of good-faith estimates of fair value for market quotations or pricing service valuations should be disclosed in the notes to the financial statements.

2.58 Paragraphs 24–27 of FASB ASC 820-10-35 describe the valuation techniques that should be used to measure fair value. The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. Three widely used valuation approaches are the market approach, cost approach, and income approach. These approaches are described in paragraphs 3A–3G of FASB ASC 820-10-55, as follows:

•     The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities, or a group of assets and liabilities, such as a business. Valuation techniques consistent with the market approach include matrix pricing and often use market multiples derived from a set of comparables.

•     The cost approach reflects the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost).

•     The income approach converts future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts. Valuation techniques consistent with the income approach include present value techniques, option-pricing models, and the multiperiod excess earnings method.

2.59 FASB ASC 820-10-35-24 states that valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs, and minimizing the use of unobservable inputs, should be used by a reporting entity. FASB ASC 820-10-35-24B explains that in some cases, a single valuation technique will be appropriate (for example, when valuing an asset or a liability using quoted prices in an active market for identical assets or liabilities). In other cases, multiple valuation techniques will be appropriate (for example, that might be the case when valuing a reporting unit). If multiple valuation techniques are used to measure fair value, the results (that is, respective indications of fair value) should be evaluated, considering the reasonableness of the range indicated by those results. FASB ASC 820-10-55-35 illustrates the use of multiple valuation techniques. A fair value measurement is the point within that range that is most representative of fair value in the circumstances.

2.60 As explained in paragraphs 25–26 of FASB ASC 820-10-35, valuation techniques used to measure fair value should be applied consistently. However, a change in a valuation technique or its application is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. Such a change would be accounted for as a change in accounting estimate, in accordance with the provisions of FASB ASC 250, Accounting Changes and Error Corrections. However, as explained in FASB ASC 250-10-50-5, the disclosures in FASB ASC 250 for a change in accounting estimate are not required for revisions resulting from a change in a valuation technique or its application when the resulting measurement is fair value in accordance with FASB ASC 820.

Present Value Techniques

2.61 Paragraphs 5–20 of FASB ASC 820-10-55 describe the use of present value techniques to measure fair value. Those paragraphs neither prescribe the use of a single specific present value technique nor limit the use of present value techniques to measure fair value to the techniques discussed therein. A fair value measurement of an asset or a liability using a present value technique captures all of the following elements from the perspective of market participants at the measurement date:

•     An estimate of future cash flows

•     Expectations about possible variations in the amount and timing of the cash flows

•     Time value of money

•     The price for bearing the uncertainty inherent in the cash flows (that is, a risk premium)

•     Other factors that market participants would take into account in the circumstances

•     For a liability, the nonperformance risk relating to that liability, including the reporting entity’s (that is, the obligor’s) own credit risk

2.62 FASB ASC 820-10-55-6 provides the general principles that govern any present value technique used to measure fair value, as follows:

•     Cash flows and discount rates should reflect assumptions that market participants would use when pricing the asset or liability.

•     Cash flows and discount rates should take into account only the factors attributable to the asset or liability being measured.

•     To avoid double counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using the contractual cash flows of a loan (that is, a discount rate adjustment technique), but is not appropriate if using expected (that is, probability-weighted) cash flows (that is, an expected present value technique) because the expected cash flows already reflect assumptions about the uncertainty in future defaults.

•     Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows, which include the effects of inflation, should be discounted at a rate that includes the effects of inflation.

•     Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.

2.63 FASB ASC 820-10-55-9 describes how present value techniques differ in how they adjust for risk and in the type of cash flows they use. For example, the discount rate adjustment technique (also called the traditional present value technique) uses a risk-adjusted discount rate and contractual, promised, or most likely cash flows. In contrast, method 1 of the expected present value technique uses risk-adjusted expected cash flows and a risk-free rate. Method 2 of the expected present value technique uses expected cash flows that are not risk adjusted and a discount rate adjusted to include the risk premium that market participants require. That rate is different from the rate used in the discount rate adjustment technique. FASB ASC 820-10-55-13 notes that, in the expected present value technique, the probability-weighted average of all possible future cash flows is referred to as the expected cash flows. The traditional present value technique and two methods of expected present value techniques are discussed more fully in FASB ASC 820-10-55.

The Fair Value Hierarchy

2.64 Because fair value is a market-based measurement, as stated in FASB ASC 820-10-35-9, fair value should be measured using the assumptions that market participants would use in pricing the asset or liability, assuming that market participants act in their economic best interest. The FASB ASC glossary defines inputs as assumptions that market participants would use when pricing the asset or liability, including assumptions about risk, such as the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) or the risk inherent in the inputs to the valuation technique. Inputs may be observable or unobservable (both as defined by the FASB ASC glossary):

•     Observable inputs are developed using market data, such as publicly available information about actual events or transactions, and reflect the assumptions that market participants would use when pricing the asset or liability.

•     Unobservable inputs are inputs for which market data are not available and are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability.

2.65 Paragraphs 37–54B of FASB ASC 820-10-35 establishes a fair value hierarchy that distinguishes between observable and unobservable inputs. FASB ASC 820-10-05-1C states that when a price for an identical asset or liability is not observable, a reporting entity measures fair value using another valuation technique that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs.

2.66 The fair value hierarchy in FASB ASC 820-10-35 prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The three levels are discussed in FASB ASC 820-10-35, and are summarized as follows:

•     Level 1 inputs. Paragraphs 40–46 of FASB ASC 820-10-35 state that level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. FASB ASC 820-10-35-44 affirms the requirement that the fair value of a position in a single asset or liability (including a position comprising a large number of identical assets or liabilities, such as a holding of financial instruments) that trades in an active market should be measured within level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the reporting entity. That is the case even if a market’s normal daily trading volume is not sufficient to absorb the quantity held, and placing orders to sell the position in a single transaction might affect the quoted price.

•     Level 2 inputs. Paragraphs 47–51 of FASB ASC 820-10-35 state that level 2 inputs are inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specified (contractual) term, a level 2 input must be observable for substantially the full term of the asset or liability. Adjustments to level 2 inputs will vary depending on factors specific to the asset or liability. Those factors include the condition or location of the asset, the extent to which inputs relate to items that are comparable to the asset (including those factors described in FASB ASC 820-10-35-16D), and the volume or level of activity in the markets within which the inputs are observed. An adjustment to a level 2 input that is significant to the entire measurement might result in a fair value measurement categorized within level 3 of the fair value hierarchy if the adjustment uses significant unobservable inputs. Level 2 inputs include the following:

—     Quoted prices for similar assets or liabilities in active markets

—     Quoted prices for identical or similar assets or liabilities in markets that are not active

—     Inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves observable at commonly quoted intervals, implied volatilities, and credit spreads)

—     Inputs that are derived principally from, or corroborated by, observable market data by correlation or other means (market-corroborated inputs)

•     Level 3 inputs. Paragraphs 52–54A of FASB ASC 820-10-35 state that level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs should be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. A reporting entity should develop unobservable inputs using the best information available in the circumstances, which might include the entity’s own data. In developing unobservable inputs, a reporting entity may begin with its own data, but it should adjust those data if reasonably available information indicates that other market participants would use different data or there is something particular to the reporting entity that is not available to other market participants (for example, an entity-specific synergy). A reporting entity need not undertake exhaustive efforts to obtain information about market participant assumptions. Unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. Assumptions about risk include the risk inherent in a particular valuation technique and the risk inherent in the inputs to the valuation technique. A measurement that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one when pricing the asset or liability. The reporting entity should take into account all information about market participant assumptions that is reasonably available.

2.67 As explained in FASB ASC 820-10-35-37A, in some cases, the inputs used to measure the fair value of an asset or a liability might be categorized within different levels of the fair value hierarchy. In those cases, the fair value measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement. Adjustments to arrive at measurements based on fair value, such as costs to sell when measuring fair value less costs to sell, should not be taken into account when determining the level of the fair value hierarchy within which a fair value measurement is categorized.

2.68 As discussed in FASB ASC 820-10-35-38, the availability of relevant inputs and their relative subjectivity might affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorized within level 2 or level 3, depending on the inputs that are significant to the entire measurement and the level of the fair value hierarchy within which those inputs are categorized.

2.69 As stated in FASB ASC 820-10-35-2C, the effect on the measurement arising from a particular characteristic will differ depending on how that characteristic would be taken into account by market participants. FASB ASC 820-10-55 paragraphs 51–55 illustrate a restriction’s effect on fair value measurement.

Application of Fair Value Measurements

2.70 FASB ASC 820-10-35-10A states that a fair value measurement of a nonfinancial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use. The FASB ASC glossary defines highest and best use as the use of a nonfinancial asset by market participants that would maximize the value of the asset or the group of assets and liabilities (for example, a business) within which the asset would be used. Further, FASB ASC 820-10-35-11A states that the fair value measurement of a nonfinancial asset assumes that the asset is sold consistent with the unit of account (which may be an individual asset). That is the case even when that fair value measurement assumes that the highest and best use of the asset is to use it in combination with other assets or with other assets and liabilities because a fair value measurement assumes that the market participant already holds the complementary assets and associated liabilities.²⁶

2.71 Investment companies sometimes hold investments that are considered to be nonfinancial assets (for example, physical commodities and real estate). FASB ASC 946-325-35-1 states that an investment company shall subsequently measure its other investments at fair value.

2.72 According to paragraphs 16–16A of FASB ASC 820-10-35, a fair value measurement assumes that a financial or nonfinancial liability or an instrument classified in a reporting entity’s shareholders’ equity is transferred to a market participant at the measurement date. The transfer of a liability or an instrument classified in a reporting entity’s shareholders’ equity assumes that (a) a liability would remain outstanding and the market participant transferee would be required to fulfill the obligation and (b) an instrument classified in a reporting entity’s shareholders’ equity would remain outstanding and the market participant transferee would take on the rights and responsibilities associated with the instrument. It is also assumed the liability or instrument would not be settled with the counterparty, cancelled, or otherwise extinguished on the measurement date. Even when there is no observable market to provide pricing information about the transfer of a liability or an instrument classified in a reporting entity’s shareholders’ equity (for example, because contractual or other legal restrictions prevent the transfer of such items), there might be an observable market for such items if they are held by other parties as assets (for example, a corporate bond or a call option on a reporting entity’s shares).

2.73 Paragraphs 16B–16BB of FASB ASC 820-10-35 states that when a quoted price for the transfer of an identical or a similar liability or instrument classified in a reporting entity’s shareholders’ equity is not available, and the identical item is held by another party as an asset, a reporting entity should measure the fair value from the perspective of a market participant that holds the identical item as an asset at the measurement date. In such cases, a reporting entity should measure the fair value of the liability or equity instrument as follows:

a.     Using the quoted price in an active market for the identical item held by another party as an asset, if that price is available

b.     If that price is not available, using other observable inputs, such as the quoted price in a market that is not active for the identical item held by another party as an asset

c.     If the observable prices in items a–b are not available, using another valuation approach, such as an income approach or a market approach

2.74 According to FASB ASC 820-10-35-16D, a reporting entity should adjust the quoted price of a liability held by another party as an asset only if there are factors specific to the asset that are not applicable to the fair value measurement of the liability or equity instrument. A reporting entity should determine that the price of the asset does not reflect the effect of a restriction preventing the sale of that asset. Some factors that may indicate that the quoted price of the asset should be adjusted include (a) the quoted price for the asset relates to a similar, but not identical, liability or equity instrument held by another party as an asset, or (b) the unit of account for the asset is not the same as for the liability or equity instrument.

2.75 According to FASB ASC 820-10-35-16H, when a quoted price for the transfer of an identical or a similar liability is not available and the identical item is not held by another party as an asset, a reporting entity should measure the fair value of the liability or equity instrument using a valuation technique from the perspective of a market participant that owes the liability or has issued the claim on equity.

2.76 When measuring the fair value of a liability, FASB ASC 820-10-35-18B states that a reporting entity should not include a separate input or an adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the item because the effect of that restriction is either implicitly or explicitly included in the other inputs to the fair value measurement. Refer to FASB ASC 820-10-35-18C for an example of the fair value measurement of a liability with such a restriction.

2.77 Paragraphs 17–18 of FASB ASC 820-10-35 provide that the fair value of a liability should reflect the effect of nonperformance risk (which includes, but is not limited to, a reporting entity’s own credit risk). Nonperformance risk is assumed to be the same before and after the transfer of the liability. When measuring the fair value of a liability, a reporting entity should take into account the effect of its credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will or will not be fulfilled.

2.78 FASB ASC 820-10-35-18A discusses fair value measurement of a liability that has an inseparable third-party credit enhancement (for example, debt that is issued with a financial guarantee from a third party that guarantees the issuer’s payment obligation). The fair value of a liability reflects the effect of nonperformance risk on the basis of its unit of account. In accordance with FASB ASC 825, Financial Instruments, the issuer of a liability issued with an inseparable third-party credit enhancement that is accounted for separately from the liability should not include the effect of the credit enhancement (for example, the third-party guarantee of debt) in the fair value measurement of the liability. If the credit enhancement is accounted for separately from the liability, the issuer would take into account its own credit standing and not that of the third-party guarantor when measuring the fair value of the liability.

2.79 Private equity funds or BDCs (collectively, a fund) may hold a controlling interest in an investee company and hold both equity and debt instruments issued by the investee. From a business strategy perspective, in this circumstance, the fund’s management may view their investment in the debt and equity instruments as an aggregate position rather than as separate financial instruments. Technical Questions and Answers (Q&A) section 6910.34, “Application of the Notion of Value Maximization for Measuring Fair Value of Debt and Controlling Equity Positions,”^27,28 discusses when it may be appropriate to apply the notion of value maximization (as discussed in paragraph BC49 of FASB Accounting Standards Update (ASU) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs) to assist management of a fund that holds a controlling interest in an investee company and hold both equity and debt instruments issued by the investee for which there are not observed trades. Paragraph BC49 of ASU No. 2011-04 states

Market participants seek to maximize the fair value of a financial or nonfinancial asset or to minimize the fair value of a financial or nonfinancial liability by acting in their economic best interest in a transaction to sell the asset or to transfer the liability in the principal (or most advantageous) market for the asset or liability. Such a transaction might involve grouping assets and liabilities in a way in which market participants would enter into a transaction, if the unit of account specified in other Topics (of the FASB ASC) does not prohibit that grouping.

2.80 This language provides fair value measurement guidance in situations when the unit of account is not specified. Because FASB ASC 946, Financial Services—Investment Companies, does not specify the unit of account for measuring fair value, it might be appropriate to consider how fair value would be maximized, which may be in a transaction that involves both the debt and controlling equity position if that is how market participants would transact.²⁹ Consistent with the guidance in paragraph BC49 of ASU No. 2011-04, this transaction (and, thus, fair value) might be measured using an enterprise value approach measured in accordance with the guidance in FASB ASC 820 (that is, an exit price from the perspective of market participants under current conditions at the measurement date).

2.81 Because the enterprise value approach results in a fair value for the entire capital position (that is, both debt and equity), an allocation to the individual units of account would be necessary. FASB ASC 820 does not prescribe an allocation approach, but FASB ASC 820-10-35-18F discusses that a “reporting entity should perform such allocations on a reasonable and consistent basis using a methodology appropriate in the circumstances.” Facts and circumstances, such as relevant characteristics of the debt and equity instruments, must be considered when making this allocation. Generally, the allocation method should be consistent with the overall valuation premise used to measure fair value.

2.82 Q&A section 6910.35, “Assessing Control When Measuring Fair Value,”³⁰ discusses when it may be appropriate to aggregate positions across multiple reporting entities (multiple funds) to assess control³¹ for purposes of whether a control premium might be appropriate in a fair value measurement. Q&A section 6910.35 explains that control of an investee company may be achieved by virtue of a single fund holding a controlling financial interest, through multiple funds in the same fund complex³² under common control being allocated financial interests in the investee company, or through “club deals” in which a group of unrelated investment managers jointly make controlling investments in a private company on behalf of funds they manage. For example, a single adviser may decide to make a controlling financial investment in an investee and then allocate that investment across multiple legal and reporting entities. Individually, no one entity may control the investee (Q&A section 6910.35 assumes this is the case); however, the entities in aggregate may have a controlling financial interest in the investee.

2.83 It is not consistent with the fair value measurement framework in FASB ASC 820 for a reporting entity to aggregate positions across multiple reporting entities (multiple related funds or unrelated club deals) to assess control³³ for purposes of whether a control premium might be appropriate in a fair value measurement. However, when determining the fair value of the position the reporting entity holds, that determination should consider whether other premiums and discounts (relative to the price of a noncontrolling interest) are appropriate. For example, observed transaction data for similar investments may indicate that market participants pay a premium multiple relative to the multiples observed for the guideline companies because some market participants place additional value on being part of the controlling group that has the right to determine the company’s strategy.

2.84 A reporting entity should consider all available evidence about how a market participant would exit the investments (and the prices it would receive) in determining the principal (or most advantageous) market and whether premiums to noncontrolling interests are appropriate.

Offsetting Positions in Market Risks or Counterparty Credit Risk

2.85 FASB ASC 820-10-35-18D provides that a reporting entity that holds a group of financial assets and financial liabilities (including derivatives) is exposed to market risks (that is, interest rate risk, currency risk, or other price risk) and to the credit risk of each of the counterparties. When certain criteria are met, reporting entities are permitted to measure the fair value of the net asset or liability on the basis of the price that would be received to sell a net long position (that is, an asset) for a particular risk exposure or paid to transfer a net short position (that is, a liability) for a particular risk exposure in an orderly transaction between market participants at the measurement date under current market conditions. This is an exception to the general fair value measurement requirements in FASB ASC 820. This exception is intended to be utilized by entities who manage exposure to certain market or counterparty risks on a net basis, and the exception allows for valuation in a manner consistent with how market participants would price the net risk position. FASB ASC 820-10-35-18E states that

A reporting entity is permitted to use the exception only if the reporting entity does all of the following:

•     Manages the group of financial assets and financial liabilities on the basis of the reporting entity’s net exposure to a particular market risk (or risks) or to the credit risk of a particular counterparty in accordance with the reporting entity’s documented risk management or investment strategy

•     Provides information on that basis about the group of financial statements and financial liabilities to the reporting entity’s management

•     Is required or has elected to measure those financial assets and financial liabilities at fair value in the statement of financial position at the end of each reporting period.

2.86 Paragraphs 18F–18L of FASB ASC 820-10-35 provide further details on this exception, including consideration of scope, financial statement presentation,³⁴ similarities between offsetting assets and liabilities (risks and duration), exposure to counterparty credit risk, and accounting policy elections.

Investments in Entities That Calculate Net Asset Value Per Share

2.87 Paragraphs 59–62 of FASB ASC 820-10-35 contain guidance for permitting the use of a practical expedient, with appropriate disclosures, when measuring the fair value of an alternative investment that does not have a readily determinable fair value if certain criteria are met. A reporting entity is permitted, as a practical expedient, to estimate the fair value of an investment within the scope of paragraphs 4–5 of FASB ASC 820-10-15 using the net asset value per share (or its equivalent, such as member units or an ownership interest in partners’ capital to which a proportionate share of net assets is attributed) of the investment, if the net asset value per share of the investment (or its equivalent) is calculated in a manner consistent with the measurement principles of FASB ASC 946 as of the reporting entity’s measurement date. FASB ASC 820-10-15-4 explains that this guidance applies only to an investment that meets both of the following criteria as of the reporting entity’s measurement date:

a.     The investment does not have a readily determinable fair value.³⁵

b.     The investment is in an investment company within the scope of FASB ASC 946 or is an investment in a real estate fund for which it is industry practice to measure investment assets at fair value on a recurring basis and to issue financial statements that are consistent with the measurement principles in FASB ASC 946.

2.88 Certain attributes of the investment (such as restrictions on redemption) and transaction prices from principal-to-principal or brokered transactions will not be considered in measuring the fair value of the investment if the practical expedient is used. The practical expedient reduces complexity and improves consistency and comparability in the application of FASB ASC 820 while reducing the costs of applying FASB ASC 820. This guidance also improves transparency by requiring additional disclosures about investments within its scope to enable users of financial statements to understand the nature and risks of investments and whether the sale of the investments is probable at amounts different from net asset value per share.

2.89 As discussed in Q&A section 2220.18, “Applicability of Practical Expedient,”³⁶ these investments, typically referred to as alternative investments, include interests in hedge funds, private equity funds, real estate funds, venture capital funds, offshore fund vehicles, commodity funds, and funds of funds. Further, Q&A section 2220.19, “Unit of Account,”³⁷ states that, for interests in alternative investments, the appropriate unit of account is the interest in the investee fund itself, not the underlying investments within the investee fund; this is because the reporting entity owns an undivided interest in the whole of the investee fund portfolio and typically lacks the ability to dispose of individual assets and liabilities in the investee fund portfolio.

2.90 FASB ASC 820-10-35-60 states that, if the net asset value obtained from the investee is not as of the reporting entity’s measurement date or is not calculated in a manner consistent with the measurement principles of FASB ASC 946, the reporting entity should consider whether an adjustment to the most recent net asset value is necessary. The objective of this adjustment would be to estimate a net asset value per share that is consistent with the aforementioned measurement principles.

2.91 Q&A section 2220.20, “Determining Whether NAV Is Calculated Consistent With FASB ASC 946, Financial Services—Investment Companies,”³⁸ provides guidance to assist management of the reporting entity in determining whether net asset value is calculated consistent with FASB ASC 946. As part of this determination, a reporting entity should independently evaluate the fair value measurement process utilized by the investee fund manager to calculate the net asset value. This evaluation is a matter of professional judgment and includes determining that the investee fund manager has an effective process and related internal controls in place to estimate the fair value of its investments that are included in the net asset value calculation. The reporting entity’s controls used to evaluate the process of the investee fund manager may include initial due diligence, ongoing monitoring, and financial reporting controls. Only after considering all relevant factors can the reporting entity reach a conclusion about whether the reported net asset value is calculated consistent with the measurement principles of FASB ASC 946. The reporting entity may consider the following key factors relating to the valuation received from the investee fund manager:

•     The investee fund’s fair value estimation processes and control environment and any changes to those processes or control environment

•     The investee’s fund policies and procedures for estimating fair value of the underlying investments and any changes to those policies or procedures

•     The use of independent third-party valuation experts to augment and validate the investee fund’s procedures for estimating fair value

•     The portion of the underlying securities held by the investee fund that are traded on active markets

•     The professional reputation and standing of the investee fund’s auditor (this is not intended to suggest that the auditor is an element of the investee fund’s internal control system but as a general risk factor in evaluating the integrity of the data obtained from the investee fund manager)

•     Qualifications, if any, of the auditor’s report on the investee fund’s financial statements

•     Whether there is a history of significant adjustments to the net asset value reported by the investee fund manager as a result of the annual financial statement audit or otherwise

•     Findings in the investee fund’s adviser or administrator’s type 2 SOC 1^® report, if any

•     Whether net asset value has been appropriately adjusted for items such as carried interest and clawbacks

•     Comparison of historical realizations to the last reported fair value

2.92 Q&A section 2220.20 goes on to discuss the scenario in which a reporting entity invests in a fund of funds. That reporting entity could conclude on the consistency of the net asset value calculation with FASB ASC 946 by assessing (a) whether the fund-of-funds manager has a process that considers the aforementioned key factors in the calculation of the net asset value reported by the fund of funds and (b) if the fund-of-funds manager has obtained or estimated the net asset value from underlying fund managers in a manner consistent with paragraphs 59–62 of FASB ASC 820-10-35 as of the measurement date. The reporting entity is not required to look through the fund-of-funds interest to underlying fund investments if the reporting entity has concluded that the fund-of-funds manager reports net asset value consistent with FASB ASC 946 for the fund-of-funds interest.

2.93 Q&A section 2220.22, “Adjusting NAV When It Is Not as of the Reporting Entity’s Measurement Date,”³⁹ illustrates how the reporting entity should estimate an adjustment when net asset value is calculated consistently with FASB ASC 946 but not as of the reporting entity’s measurement date. One option is for the reporting entity to request the investee fund manager to provide a supplemental net asset value calculation consistent with the measurement principles of FASB ASC 946 as of the reporting entity’s measurement date. Alternatively, it may be necessary to adjust or roll forward (or roll back) the reported net asset value for factors that could cause it to differ from the net asset value at the measurement date. When the reporting entity’s measurement date is prior to the net asset value calculation date, it may be more appropriate to use that net asset value and perform a rollback, rather than using a reported net asset value calculated prior to the entity’s measurement date. Q&A section 2220.22 lists factors that may necessitate an adjustment to the reported net asset value when it is not calculated as of the reporting entity’s measurement date and contains an example rollforward net asset value calculation.

2.94 Q&A section 2220.23, “Adjusting NAV When It Is Not Calculated Consistent With FASB ASC 946,”⁴⁰ illustrates how a reporting entity may estimate the adjustment when a reported net asset value is not calculated consistently with the measurement principles of FASB ASC 946. In this situation, the reporting entity should consider and understand the reasons why net asset value has not been based upon fair value, whether a fair value based net asset value can be obtained from the investee manager, and whether the specific data needed to adjust the reported net asset value can be obtained and properly utilized to estimate a fair value based net asset value. Some examples of circumstances in which the reporting entity may be able to obtain data to estimate an adjustment include, but are not limited to, the reported net asset value is on a cash basis, the reported net asset value utilizes blockage discounts taken in determining the fair value of investment securities (which is inconsistent with FASB ASC 820; see paragraph 2.43 for further consideration of premiums and discounts in fair value measurements), and the reported net asset value has not been adjusted for the impact of unrealized carried interest or incentive fees. Consequently, if the reporting entity finds that it is not practicable to calculate an adjusted net asset value, then the practical expedient is not available. The reporting entity may also elect not to utilize the practical expedient. In those cases, the reporting entity should apply the general measurement principles of FASB ASC 820 instead.

2.95 FASB ASC 820-10-35-61 states that a reporting entity should decide on an investment-by-investment basis whether to apply the practical expedient and should apply the practical expedient consistently to the fair value measurement of the reporting entity’s entire position in a particular investment, unless it is probable at the measurement date that the reporting entity will sell a portion of an investment at an amount different from net asset value per share (or its equivalent), as described in FASB ASC 820-10-35-62 (see the following paragraph). In those situations, the reporting entity should account for the portion of the investment that is being sold in accordance with other provisions in FASB ASC 820 and should not apply the practical expedient discussed in FASB ASC 820-10-35-59.

2.96 According to FASB ASC 820-10-35-62, a reporting entity is not permitted to estimate the fair value of an investment (or a portion of the investment) within the scope of paragraphs 4–5 of FASB ASC 820-10-15 using the net asset value per share of the investment (or its equivalent) as a practical expedient if it is probable at the measurement date that a reporting entity will sell the investment at an amount different from the net asset value per share (or its equivalent). A sale is considered probable only if all of the following criteria are met as of the reporting entity’s measurement date:

•     Management, having the authority to approve the action, commits to a plan to sell the investment.

•     An active program to locate a buyer and other actions required to complete the plan to sell the investment have been initiated.

•     The investment is available for immediate sale subject only to terms that are usual and customary for sales of such investments.

•     Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

2.97 Q&A section 2220.27, “Determining Fair Value of Investments When the Practical Expedient Is Not Used or Is Not Available,”⁴¹ discusses what inputs or investment features should be considered in estimating fair value for entities that do not elect to use net asset value as a practical expedient or are unable to adjust the most recently reported net asset value to estimate a net asset value that is calculated in a manner consistent with the measurement principles of FASB ASC 946 as of the reporting entity’s measurement date. In this situation, examples of factors that could be used when estimating fair value (depending on the valuation technique[s] and facts and circumstances) are as follows:

•     Net asset value (as one valuation factor)

•     Transactions in principal-to-principal or brokered markets (external markets) and overall market conditions

•     Features of the alternative investment

•     Expected future cash flows appropriately discounted

•     Factors used to determine whether there has been a significant decrease in the volume or level of activity for the asset or liability when compared with normal activity (FASB ASC 820-10-35-54C).

2.98 Q&A section 2220.27 discusses several investment features of alternative investments in detail, including lockup periods and the ability of the fund to identify and make acceptable investments. A reporting entity may consider these investment features in determining fair value when the practical expedient is unavailable or not elected.

2.99 According to paragraph 54B of FASB ASC 820-10-35, categorization within the fair value hierarchy of an investment that is measured at net asset value per share is not permitted. Paragraph 54B indicates that the disclosures described in FASB ASC 820-10-50-6 apply to an investment for which fair value is measured using net asset value per share (or its equivalent) as a practical expedient. Paragraph 54B also indicates that reporting entities should provide the amount measured using the net asset value per share (or its equivalent) practical expedient to permit reconciliation of the fair value of investments included in the fair value hierarchy to the line items presented in the statement of financial position.

2.100 Q&A section 2220.24, “Disclosures—Ability to Redeem Versus Actual Redemption Request,” discusses redemptions from alternative funds. In most cases, redemptions at net asset value are only permitted with advance notice, ranging from 30 to 120 days. Even if the reporting entity has not submitted a redemption request effective on the measurement date, as long as the reporting entity has the ability to redeem at net asset value in the near term (for example, it has the contractual and practical ability to redeem) at the measurement date, then, consistent with FASB ASC 820-10-35-54B(a), the investment may be classified within level 2 of the fair value hierarchy. Q&A section 2220.25, “Impact of ‘Near Term’ on Classification Within Fair Value Hierarchy,” explains that what is viewed as near term is a matter of professional judgment and depends on the specific facts and circumstances. A redemption period of 90 days or less generally would be considered near term because any potential discount relative to the time value of money to the next redemption date would be unlikely to be considered a significant unobservable input, in accordance with FASB ASC 820. However, other factors, such as the likelihood or actual imposition of gates, may influence the determination of whether the investment will be redeemable in the near term.

Money Market Funds

2.101 As set forth in Rule 2a-7 under the 1940 Act, a money market fund may value securities using the amortized cost or penny-rounding method,⁴² subject to certain determinations by its board of directors or trustees. Rule 2a-7 requires, among other things, in the case of a money market fund using the amortized cost method, that the fund’s board of directors or trustees “establish written procedures reasonably designed ... to stabilize the money market fund’s net asset value per share, as computed for the purpose of distribution, redemption and repurchase at a single value.” Rule 2a-7 sets forth procedures that must be adopted by the board of directors or trustees when using the amortized cost or penny-rounding method of valuation. Additionally, for funds using the amortized cost method, the board of directors or trustees should perform a periodic review of both the monitoring of and the extent of any deviation from fair value and the methods used to calculate the deviations.

Valuation of securities by money market funds is set forth in Rule 2a-7 of the 1940 Act.

•     Retail money market funds may value securities using the amortized cost or penny-rounding method,⁴³ subject to certain determinations by its board of directors or trustees. Rule 2a-7 requires, among other things, in the case of a money market fund using the amortized cost method, that the fund’s board of directors or trustees “establish written procedures reasonably designed ... to stabilize the money market fund’s net asset value per share, as computed for the purpose of distribution, redemption and repurchase at a single value.” Rule 2a-7 sets forth procedures that must be adopted by the board of directors or trustees when using the amortized cost or penny-rounding method of valuation. Additionally, for funds using the amortized cost method, the board of directors or trustees should perform a periodic review of both the monitoring of and the extent of any deviation from fair value and the methods used to calculate the deviations.

•     Institutional prime funds are required to price and transact in their shares at market-based value, like all other mutual funds. This requirement resulted from the SEC’s issuance of Final Rule Release No. 33-9616, Money Market Fund Reform; Amendments to Form PF. Among other provisions, the final rule rescinds a valuation exemption that permitted institutional prime funds to maintain a stable NAV. Under the final rule amendments, government and retail money market funds are permitted to continue to use the amortized cost method and/or penny-rounding method to maintain a stable price per share.

Determining Costs and Realized Gains and Losses

2.102 As stated in FASB ASC 946-320-40-1, the cost of investment securities held in the portfolio of an investment company and the net realized gains or losses thereon should be determined on the specific identification or average-cost methods. An investment company should use only one method for all of its investments.

2.103 Rule 2a-2 of the 1940 Act states that the cost of investment securities held in the portfolio of a registered investment company and the net realized gains or losses thereon are determined, for financial accounting purposes, on the specific certificate, first in first out, last in first out, or average-value methods. The average-value method of computing gains and losses may not presently be used for federal income tax purposes.

2.104 An investment company occasionally may be entitled to receive award proceeds from litigation relating to an investment security. Awards should be recorded in accordance with the gain contingency provisions of FASB ASC 450, Contingencies, considering such factors as the enforceability of the right to settlement and the ability to determine the amount receivable.

2.105 As explained in FASB ASC 946-320-35-21, if the investment company holds the securities, the proceeds from litigation awards are accounted for as a reduction of cost. If the investment company no longer holds the securities, the proceeds should be accounted for as realized gains on security transactions.

2.106 As provided in paragraphs 2–3 of FASB ASC 946-320-30, an investment company may receive securities in a spin-off wherein the entity in which the investment company has invested spins off a portion of its operations. A portion of the cost of the securities held should be allocated to the securities received in the spin-off. That amount is based on the ratio of the fair value of the securities received to the sum of the fair value of such securities and the fair value of the original securities held by the investment company of the entity affecting the spin-off.

2.107 Spin-offs are usually tax-free reorganizations, and no gain or loss is recognized for income tax or financial reporting purposes.⁴⁴

2.108 From time to time, tender offers may be received for securities held by an investment company. The terms of the offer may be for cash, debentures of the acquiring entity, stock of the acquiring entity, or a combination thereof.

2.109 As explained in FASB ASC 946-320-25-3, even if the investment company tenders its securities, it should continue to value the shares tendered until the number of shares accepted in the tender is known. Thereafter, the investment company should value the assets to be received for the shares tendered.

2.110 Accrued interest on bonds bought between interest dates should be accounted for as accrued interest receivable. Accrued interest on bonds sold should be accounted for as a reduction of accrued interest receivable and is not a factor in determining gain or loss on a sale.

Accounting for Investment Income⁴⁵

2.111 An investment company’s investment income consists primarily of dividends and interest.

2.112 Dividends. As stated in FASB ASC 946-320-35-5, dividends on investment securities should be recorded on the ex-dividend date. Distributions that represent returns of capital should be credited to investment cost rather than investment income.

2.113 As provided in FASB ASC 946-320-35-6, stock splits and stock dividends in shares of the same class as the shares owned are not income to the investment company. However, dividends for which the recipient has the choice to receive cash or stock are usually recognized as investment income in the amount of the cash option because, in such cases, cash is usually the best evidence of fair value of the stock.

2.114 FASB ASC 946-320-35-7 states that other noncash dividends should be recognized as investment income at the fair value of the property received.

2.115 FASB ASC 946-320-35-8 explains that stock rights (that is, subscription rights) received should be allocated a prorated portion of the cost basis of the related investment; however, allocation is not required if the fair value of the rights is 15 percent or less of the fair value of the investment company’s holdings.

2.116 Investment companies usually follow tax accounting from IRC Section 307 that, consistent with the guidance of the prior paragraph, does not require allocation if the fair value of the stock rights is 15 percent or less of the fair value of the investment company’s holdings.

2.117 As stated in FASB ASC 946-320-35-9, cash dividends declared on stocks for which the securities portfolio reflects a short position as of the record date should be recognized as an expense on the ex-dividend date.

2.118 As a routine operating policy, investment companies should consult reliable published or other sources for daily dividend declarations and other corporate actions to be sure that they obtain and record relevant dividend information in a timely manner. Investment companies should have procedures that provide for follow up and disposition of dividends not collected in the regular course of business because of delays in settling securities transactions or completing transfer procedures.

2.119 Interest. As stated in FASB ASC 946-320-35-20, premiums and discounts should be amortized using the interest method. As explained in FASB ASC 310-20-35-18, the objective of the interest method is to arrive at periodic interest income (including recognition of fees and costs) at a constant effective yield on the net investment (that is, the principal amount of the investment adjusted by unamortized fees or costs and purchase premium or discount). FASB ASC 835-30-35-2 states that the difference between the present value and the face amount of the net investment should be treated as a discount or premium and amortized as interest expense or income over the life of the note in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period.

2.120 The economic substance of an investment in a debt security is that the discount or premium paid is generally an adjustment of the stated interest rate to an acquisition market rate. Amortizing premiums and accreting discounts, as an adjustment to interest income, is consistent with the economic substance of the transaction.

2.121 Paydown gains and losses on mortgage- and asset-backed securities should also be presented as an adjustment to interest income. Amortization of bond premiums and accretion of bond discounts for federal income tax purposes is discussed in chapter 6, “Taxes,” of this guide. Original issue discount on bonds and other debt securities is required to be amortized for tax and financial reporting purposes. Discounts on the purchase of bonds that do not provide for periodic interest payments, sometimes called zero coupon bonds, should be amortized to income by the interest method.

2.122 FASB ASC 325-40-15-7 states that for income recognition purposes, beneficial interests classified as trading are included in the scope of FASB ASC 325-40 because it is practice for certain industries (such as investment companies) to report interest income as a separate item in their income statements, even though the investments are accounted for at fair value. The FASB ASC glossary defines beneficial interests as rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, all of the following: senior and subordinated shares of interest, principal, or other cash inflows to be passed through or paid through; premiums due to guarantors; commercial paper obligations; and residual interests, whether in the form of debt or equity.

2.123 FASB ASC 325-40-35-1 explains that the holder of a beneficial interest should recognize accretable yield as interest income over the life of the beneficial interest using the effective yield method. The holder of a beneficial interest should continue to update, over the life of the beneficial interest, the expectation of cash flows to be collected. FASB ASC 325-40-35-3 goes on to explain that after the transaction date, cash flows expected to be collected are defined as the holder’s estimate of the amount and timing of estimated principal and interest cash flows based on the holder’s best estimate of current information and events. In FASB ASC 325-40, a change in cash flows expected to be collected is considered in the context of both the timing and amount of the cash flows expected to be collected.

2.124 FASB ASC 325-40-35-4 notes that, if based on current information and events, there is a favorable (or an adverse) change in cash flows expected to be collected from the cash flows previously projected, then the investor should recalculate the amount of accretable yield for the beneficial interest on the date of evaluation as the excess of cash flows expected to be collected over the beneficial interest’s reference amount. The reference amount equals the initial investment minus cash received to date plus the yield accreted to date. Based on cash flows expected to be collected, interest income may be recognized on a beneficial interest even if the net investment in the beneficial interest is accreted to an amount greater than the amount at which the beneficial interest could be settled if prepaid immediately in its entirety. The adjustment should be accounted for prospectively as a change in estimate, in conformity with FASB ASC 250, with the amount of periodic accretion adjusted over the remaining life of the beneficial interest.

2.125 Paragraphs 5–6 of FASB ASC 325-40-35 explain that determining whether there has been a favorable (or an adverse) change in cash flows expected to be collected from the cash flows previously projected (taking into consideration both the timing and amount of the cash flows expected to be collected) involves comparing the present value of the remaining cash flows expected to be collected at the initial transaction date (or at the last date previously revised) against the present value of the cash flows expected to be collected at the current financial reporting date. The cash flows should be discounted at a rate equal to the current yield used to accrete the beneficial interest.

2.126 According to Q&A section 6910.21, “Recognition of Premium/Discount on Short Positions in Fixed-Income Securities,” when recognizing interest income on long positions or when recognizing interest expense on short positions on fixed-income securities, all economic elements of interest should be recognized, including premium and discount to the par value of the bond.

2.127 Interest income on debt securities, such as corporate bonds, municipal bonds, or treasury bonds, is accrued daily. An investment company should also consider collectability of interest when making accruals.

2.128 Interest received on bonds that were in default or that were delinquent in the payment of interest when acquired should be accounted for as follows: (a) the amount of interest earned from the date of acquisition of the bond through the current period should be recorded as interest income, and (b) the amount of interest in arrears at the date of acquisition of the bond should be recorded as a reduction of the cost of the investment.⁴⁶

2.129 The accrued interest receivable account should be analyzed at regular intervals to make sure that interest payments due are received promptly and in the correct amount. Similarly, the disposition of purchased interest receivable and interest accruals on debt securities sold between interest dates should be analyzed periodically.

Defaulted Debt Securities

2.130 Consistent with the guidance for contingencies in FASB ASC 450-20-25-2, accrued interest should be written off when it becomes probable that the interest will not be collected, and the amount of uncollectible interest can be reasonably estimated.

2.131 As explained in paragraphs 17–18 of FASB ASC 946-320-35, the portion of interest receivable on defaulted debt securities written off that was recognized as interest income should be treated as a reduction of interest income. Write-offs of purchased interest should be reported as increases to the cost basis of the security, which will result in an unrealized loss until the security is sold.

Accounting for Expenditures in Support of Defaulted Debt Securities

2.132 As noted in FASB ASC 946-320-05-9, when issuers of debt securities default, the bondholders often become active in any negotiations and the workout process. This process often results in new terms that restructure the obligations to allow the issuer to continue to meet its ongoing interest obligations and maintain some, if not all, of the principal value to the holders of the obligations.

2.133 As explained in FASB ASC 946-320-05-10, adverse economic developments often lead to increases in the default rates of debt securities. In addition to occasional capital infusions, professional fees to legally restructure the investments are frequently incurred by the bondholders.

2.134 Capital infusions. The nature of capital infusions is to enhance or prevent substantial diminution in the fair value of the investment. According to the FASB ASC glossary, capital infusions are expenditures made directly to the issuer to ensure that operations are completed, thereby allowing the issuer to generate cash flows to service the debt. Such expenditures are usually nonrecurring. In certain cases, bondholders may receive additional promissory notes, or the original bond instrument may be amended to provide for repayment of the capital infusions. As further noted in FASB ASC 946-320-35-14, all capital infusions in support of defaulted securities should be recorded as an addition to the cost basis of the related security.

2.135 Workout expenditures. According to the FASB ASC glossary, workout expenditures consist of professional fees (legal, accounting, appraisal) paid to entities unaffiliated with the investment company’s adviser or sponsor in connection with (a) capital infusions, (b) restructurings or plans of reorganization, (c) ongoing efforts to protect or enhance an investment, or (d) the pursuit of other claims or legal actions. Paragraphs 15–16 of FASB ASC 946-320-35 further explain that workout expenditures that are incurred as part of negotiations of the terms and requirements of capital infusions or that are expected to result in the restructuring of, or a plan of reorganization for, an investment should be recorded as realized losses. Ongoing expenditures to protect or enhance an investment or expenditures incurred to pursue other claims or legal actions should be treated as operating expenses.

2.136 Required disclosure information associated with credit enhancements and financial support provided, or contractually required to provide, to investees are discussed in paragraphs 7.42–.43 of this guide.

Lending of Portfolio Securities and Secured Borrowings

2.137 Investment companies may lend securities (principally to broker-dealers). Such transactions are documented as loans of securities in which the borrower of securities generally is required to provide collateral to the lender, commonly cash but sometimes other securities or standby letters of credit, with a value slightly higher than that of the securities borrowed. If the asset received as collateral is cash, the lender of securities normally earns a return by investing that cash, typically in short-term, high-quality debt instruments, at rates higher than the rate paid or rebated to the borrower. Investment of cash collateral is subject to the investment company’s investment restrictions. If the asset received as collateral is other than cash, the lender of securities typically receives a fee. The investment company, as lender of securities, receives amounts from the borrower equivalent to dividends and interest on the securities loaned. As with other extensions of credit, there are risks of delay in recovery or even loss of rights in the collateral should the borrower of the securities fail financially.

2.138 Paragraphs 5A and 24A of FASB ASC 860-10-40 state that a repo-to-maturity transaction, referring to a repurchase of the same (or substantially the same) financial asset, should be accounted for as a secured borrowing as if the transferor maintains effective control, notwithstanding the characteristics discussed in paragraphs 24–24A of FASB ASC 860-10-40.

2.139 An agreement that both entitles and obligates the transferor to repurchase or redeem transferred financial assets from the transferee before the maturity date of the transferred assets maintains the transferor’s effective control over those assets under FASB ASC 860-10-40-5(c)(1), provided that all the conditions in FASB ASC 860-10-40-24⁴⁷ are met. Those transactions should be accounted for as secured borrowings in which either cash or securities received as collateral that the holder is permitted, by contract or by custom, to sell or repledge is considered the amount borrowed. In a securities lending transaction, the securities loaned are considered pledged as collateral against the cash borrowed and therefore reclassified as pledged, separately from other assets not so encumbered, as set forth in FASB ASC 860-30-25-5(a).

2.140 FASB ASC 860-10-55-51A states that under certain agreements to repurchase transferred financial assets before their maturity date, the transferor maintains effective control over the transferred financial assets. If effective control is maintained or the transaction qualifies for the repurchase-to-maturity transaction exception, the agreement is accounted for as a secured borrowing. If effective control is not maintained or the repurchase-to-maturity transaction exception is not met, the transaction would be assessed under the other derecognition conditions in FASB ASC 860-10-40-5 to determine if the transferred financial asset should be derecognized and accounted for as a sale. FASB ASC 860-10-55-51B illustrates the application of the derecognition guidance in paragraphs 24–24A of FASB ASC 860-10-40.

2.141 Repurchase agreements and securities lending transactions are required to be evaluated under each of the conditions for derecognition in accordance with FASB ASC 860-10-40-5. FASB ASC 860-10-55-51 states that repurchase agreements and securities lending transactions that do not meet all the conditions in FASB ASC 860-10-40-5 should be treated as secured borrowings.

2.142 FASB ASC 860-30 provides guidance related to transfers of financial assets⁴⁸ that are accounted for as secured borrowings with a transfer of collateral. This guidance applies to transactions in which cash is obtained in exchange for financial assets with an obligation to enter into an opposite exchange at a later date, including repurchase agreements, dollar rolls, and securities lending transactions. FASB ASC 860-30-25-2 notes that the transferor and transferee should account for a transfer as a secured borrowing with a pledge of collateral in either of the following circumstances:

•     If a transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset does not meet the conditions for a sale in FASB ASC 860-10-40-5

•     If a transfer of a portion of an entire financial asset does not meet the definition of a participating interest

2.143 In either of these circumstances, the transferor should continue to report the transferred financial asset on its statement of financial condition with no change in the asset’s measurement (for example, its basis of accounting).

2.144 FASB ASC 860-30-25-5 states that the accounting for noncash collateral by the obligor (or debtor) and the secured party depends on whether the secured party has the right to sell or repledge the collateral and whether the debtor has defaulted. As noted in FASB ASC 860-30-25-4, in certain cases, cash collateral should be derecognized by the payer (obligor) and recognized by the recipient (secured party) as proceeds of either a sale or borrowing, rather than as collateral. FASB ASC 860-30 provides additional guidance on accounting for collateral.

2.145 FASB ASC 860-30-25-8 states that the transferor of securities being loaned accounts for cash received in the same way whether the transfer is accounted for as a sale or secured borrowing. Cash collateral or securities received as collateral that a securities lender is permitted to sell or repledge are the proceeds of a borrowing secured by them. The cash received should be recognized as the transferor’s asset—as should investments made with that cash, even if made by agents or in pools with other securities lenders—along with the obligation to return the cash. If securities that may be sold or repledged are received, the transferor of the securities being loaned accounts for those securities in the same way as it would account for cash received.

Accounting for Derivatives

2.146 FASB ASC 815, Derivatives and Hedging, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (referred to collectively as derivatives), and hedging activities. FASB ASC 815-10-15-83 defines a derivative instrument as a financial instrument or other contract with all of the following characteristics:

a.     It has (i) one or more underlying instruments and (ii) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.

b.     It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

c.     Its terms implicitly or explicitly require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

2.147 FASB ASC 815 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value, and recognize changes to fair value in the statement of operations for those not designated as hedging instruments.

2.148 FASB ASC 815-10-50 contains extensive disclosure requirements for derivatives. Refer to the full text of FASB ASC 815 when testing accounting and reporting issues related to derivative instruments.

2.149 The following transactions may meet the definition of a derivative, and therefore require certain additional disclosures:

•     Swaps (credit default, interest rate, total return, and currency)

•     Future contracts (eurodollar, treasuries, municipal bond indexes, equity indexes, commodities, individual stocks, foreign bonds)

•     Forward currency contracts, interest rate caps and floors

•     Purchased and written options (equities, indices, futures, currencies, treasuries, and the like)

•     Swaptions (total return, credit default and interest rate swaps)

•     Certain capital support arrangements (for example, money market fund support agreements to maintain a $1.00 net asset value)

•     Certain warrants (refer to chapter 3, “Financial Instruments,” of this guide for further discussion relating to when a warrant could be considered a derivative)

Accounting for Foreign Investments

2.150 Investments in securities of foreign issuers involve considerations not typically associated with domestic investments. Foreign securities are denominated and pay distributions in foreign currencies, exposing investment companies to changes in foreign currency exchange rates. Investments in certain foreign countries may include the risk of expropriation or confiscatory taxation, limitations on the removal of funds or other assets, political or social instability, or adverse diplomatic developments. Individual foreign economies may differ from the economy of the United States in growth of gross domestic product, rates of inflation, capital reinvestments, resource self-sufficiency, and balance of payments positions. Securities of many foreign entities may be less liquid and their prices more volatile.

2.151 Because most foreign securities are not registered with the SEC, most of the issuers of foreign securities are not subject to the SEC’s reporting requirements. As a result, financial or regulatory information concerning certain foreign issuers of securities may not be as readily available. Also, foreign entities may not be subject to uniform accounting, auditing, and financial reporting standards or practices and requirements comparable to those that apply to domestic entities. Further, many foreign stock markets are not as developed or efficient as those in the United States. Fixed commissions on transactions on foreign stock exchanges usually are higher than negotiated commissions on U.S. exchanges. The time between the trade and settlement dates of securities transactions on foreign exchanges ranges from one day to four weeks or longer.

2.152 Foreign exchange transactions may be conducted on a cash basis at the prevailing spot rate for buying or selling the currency. Under normal market conditions, the spot rate differs from the published exchange rate because of the costs of converting from one currency to another. Some funds use forward foreign exchange contracts as hedges against possible changes in foreign exchange rates. These funds contract to buy or sell specified currencies at specified future dates and prices that are established when the contract is initiated. Dealings in forward foreign exchange contracts may relate to specific receivables or payables occurring in connection with the purchase or sale of portfolio securities, hedging all or a portion of a portfolio or the payment of dividends and other distributions.⁴⁹

2.153 The cost of foreign currency transactions varies with such factors as the currency involved, the length of the contract period, and prevailing market conditions. Because exchanges in foreign currencies are usually transacted by principals, most often, there are no fees or commissions.

2.154 As an alternative to buying shares of foreign-based entities in overseas markets, investment companies can buy shares in the United States, denominated in U.S. dollars (for example, American depository receipts [ADRs]). These receipts are for shares of a foreign-based corporation that are held by a U.S. bank as trustee. The trustee bank collects dividends and makes payments to the holders of the ADR. The trustee bank may charge holders of ADRs a custody fee for the work it performs on the ADR including performing registration, compliance, dividend payment, communication and recordkeeping services. Trustee banks commonly subtract such fees from the gross dividends payable to ADR holders.

2.155 Valuation of foreign securities. FASB ASC 946-320-35-4 states that, in general, the discussion of valuation of securities in the related subtopic of FASB ASC 946-320 (and in this chapter) also applies to foreign securities. Portfolio securities that are traded primarily on foreign securities exchanges should be valued at the functional currency (usually the U.S. dollar equivalent) values for such securities on their exchanges.

2.156 Other matters. In addition to the foreign currency risk associated with investing in foreign securities, such investments present the following additional risks that need to be assessed continuously by management and considered for financial statement disclosure, as stated in FASB ASC 946-830-50-2:

•     Liquidity. Because certain foreign markets are illiquid, market prices may not necessarily represent realizable value.

•     Size. If market capitalization is low, a fund’s share in the entire market (particularly if single-country funds are involved) or in specific securities may be proportionately very large, and the fair value, consistent with FASB ASC 820, may not be representative of the price that would be received if the fund sold its large proportion of the specific security (“block”) at the measurement date.

•     Valuation. Because of liquidity and size problems, as well as other factors, such as securities that are unlisted or thinly traded, funds would have to adopt specific fair valuation procedures for determining the values of such securities and doing so may be difficult in a foreign environment; although others may perform the research and provide supporting documentation for fair values, the ultimate responsibility for determining the fair values of securities rests with the management.

2.157 FASB ASC 946-830-50-3 explains that the disclosures suggested in the prior paragraph are no different from those that could be required for domestic securities with the same attributes. The preceding risks should be disclosed in the notes to the financial statements if such factors exist in the markets in which the fund has material investments.

2.158 Management should also make sure that prices provided by local sources (such as the last sale price, bid or ask, mean of bid and ask, closing price, and so on) do represent the fair value of the securities. This is especially important for open-end funds or closed-end funds that allow limited redemption.

2.159 Gains and losses from foreign investment holdings and transactions.⁵⁰ As stated in paragraphs 2–4 of FASB ASC 946-830-45, the differences between originally recorded amounts and currently consummated or measured amounts in the reporting currency are a function of changes in both of the following factors: foreign exchange rates and changes in market prices. Those effects should be identified, computed, and reported other than for gains and losses on investments. The practice of not disclosing separately the portion of the changes in fair values of investments and realized gains and losses thereon that result from foreign currency rate changes is permitted. However, separate reporting of such gains and losses is allowable and, if adopted by the reporting entity, should conform to the guidance in FASB ASC 946-830. Refer to appendix F, “Illustrations for Separately Calculating and Disclosing the Foreign Currency Element of Realized and Unrealized Gains and Losses,” of this guide for illustrations of separately calculating and disclosing the foreign currency element of realized and unrealized gains and losses.

2.160 As explained in FASB ASC 946-830-45-15, a fund investing in foreign securities generally invests in such securities to reap the potential benefits offered by the local capital market. It may also invest in such securities as a means of investing in the foreign currency market or benefiting from the foreign currency rate fluctuation. The extent to which separate information regarding foreign currency gains or losses will be meaningful will vary, depending on the circumstances, and separate information may not measure with precision foreign exchange gains or losses associated with the economic risks of foreign currency exposures. A foreign currency rate fluctuation, however, may be an important consideration in the case of foreign investments, and a reporting entity may choose to identify and report separately any resulting foreign currency gains or losses as a component of unrealized gain or loss on investments.

2.161 Bifurcation. As noted in FASB ASC 946-830-45-16, the fair value of securities should be determined initially in the foreign currency and translated at the spot rate on the purchase trade date. The unrealized gain or loss between the original cost (translated on the trade date) and the fair value (translated on the valuation date) comprises both of the following elements:

a.     Changes in the fair value of securities before translation

b.     Movement in foreign currency rate

2.162 FASB ASC 946-830-45-17 states that such movements may be combined as permitted by FASB ASC 946-830-45-4. If separate disclosure of the foreign currency gains and losses is chosen, the changes in the fair value of securities before translation should be measured as the difference between the fair value in foreign currency and the original cost in foreign currency translated at the spot rate on the valuation date. The effect of the movement in the foreign exchange rate shall be measured as the difference between the original cost in foreign currency translated at the current spot rate and the historical functional currency cost. These values can be computed as follows:

a.     (Fair value in foreign currency – original cost in foreign currency) × valuation date spot rate = unrealized fair value appreciation or depreciation

b.     (Cost in foreign currency × valuation date spot rate) – cost in functional currency = unrealized foreign currency gain or loss

2.163 FASB ASC 946-830-45-19 notes that, for short-term securities held by a fund that uses the amortized cost method of valuation, the amortized cost value should be substituted for fair value in the preceding formulas if separate reporting is chosen by the reporting entity.

2.164 Sales of securities. FASB ASC 946-830-45-20 explains that if separate reporting of foreign currency gains and losses on sales of securities is chosen by the reporting entity, the computation of the effects of market change and the foreign currency rate change is similar to that described in paragraph 2.162. Fair value in the formula given in paragraph 2.162 should be replaced with sale proceeds, and the valuation date should be replaced with the sale trade date, as follows:

a.     (Sale proceeds in foreign currency – original cost in foreign currency) × sale trade date spot rate = realized market gain or loss on sale of security

b.     (Cost in foreign currency × sale trade date spot rate) – cost in functional currency = realized foreign currency gain or loss

2.165 As discussed in FASB ASC 946-830-45-21, the sale of a security results in a receivable for the security sold. That receivable should be recorded on the trade date at the spot rate. On the settlement date, the difference between the recorded receivable amount and the actual foreign currency received converted into the functional currency at the spot rate is recognized as a realized foreign currency gain or loss.

2.166 Purchased interest and sale of interest. FASB ASC 946-830-45-14 explains that purchased interest represents the interest accrued between the last coupon date and the settlement date of the purchase. It should be recorded in the functional currency as accrued interest receivable at the spot rate on the purchase trade date and marked to market using each valuation date’s spot rate. After the settlement date, daily interest income should be accrued at the daily spot rate. It may be impractical to prepare the foregoing calculations daily; therefore, the use of a weekly or monthly average rate may be appropriate in many cases, especially if the exchange rate does not fluctuate significantly. However, if the exchange rate fluctuation is significant, the calculation should be made daily.

2.167 As stated by FASB ASC 946-830-45-22, interest sold represents the accrued interest receivable between the last coupon date and the settlement date of sale of the security. The difference between the recognized interest receivable amount and the actual foreign currency received (converted into the functional currency at the spot rate) should be recognized as a realized foreign currency gain or loss.

2.168 Receivables and payables. As explained in FASB ASC 946-830-45-23, all receivables and payables that are denominated in a foreign currency relating to income or expense or securities sold or purchased should be translated into the functional currency at each valuation date at the spot rate on that date. The difference between that amount and the functional currency amount that was recorded at various spot rates for income and expense items and at the trade date spot rate, in the case of sales and purchases of securities, is unrealized foreign currency gain or loss. Upon liquidation of the receivable or payable balance in a foreign currency, the difference should be reclassified as realized foreign currency gain or loss.

2.169 Cash. As explained in FASB ASC 946-830-45-7, foreign currency cash balances and movements should be accounted for in the same way that foreign currency-denominated securities are. Every receipt of a foreign currency should be treated as a purchase of a security and recorded in the functional currency at the spot rate on the cash receipt date. Similarly, every disbursement of a foreign currency should be treated as a sale of a security and the appropriate functional currency cost should be released, depending on whether a specific identified cost, first-in first-out method, or average cost method is used.

2.170 Paragraphs 8–9 of FASB ASC 946-830-45 state that the acquisition of foreign currency does not result in any foreign currency gain or loss. However, the disbursement of foreign currency results in a realized foreign currency gain or loss that is the difference between the functional currency equivalent of the foreign currency when it was acquired and the foreign currency disbursement translated at the spot rate on the disbursement date. Also, as is the case with all other assets and liabilities denominated in foreign currency, foreign currency cash balances should be translated on each valuation date at the spot rate on that date, resulting in unrealized foreign currency gain or loss.

2.171 Dividends and interest. As noted in FASB ASC 946-830-45-31, dividend income on securities denominated in a foreign currency should be recorded on the ex-dividend date using the spot exchange rate to translate the foreign currency amount into the functional currency on that date. The related dividend receivable should be translated into the functional currency daily at the spot rate, and the difference between the dividend accrued in the functional currency and the foreign currency receivable at the valuation date spot rate is unrealized foreign currency gain or loss. When the dividend is received, the unrealized foreign currency gain or loss should be reclassified as realized foreign currency gain or loss.

2.172 Further, FASB ASC 946-830-45-32 notes that the preceding approach to measuring investment income ensures that investment income accrued on foreign securities reflects the investment transaction without regard to the foreign currency gain or loss created in the time between the accrual and collection of the income.

2.173 FASB ASC 946-830-45-25 explains that interest on securities denominated in a foreign currency should be calculated at the stated rate of interest in the foreign currency. Interest on these securities should be accrued daily in the foreign currency at the stated interest rate and translated into the functional currency at the daily spot rate. Preparing such a calculation daily may be impractical; therefore, the use of a weekly or monthly average rate may be appropriate in many cases, especially if the exchange rate does not fluctuate significantly. However, if the exchange rate fluctuation is significant, the calculation should be made daily.

2.174 As noted in FASB ASC 946-830-45-26, the related receivable balance along with purchased interest, if any, should be accumulated in the foreign currency and translated into the functional currency daily using the spot rate for that date. The difference between the income accrued in the functional currency and the foreign currency receivable at the valuation date spot rate is unrealized foreign currency gain or loss.

2.175 As further stated in FASB ASC 946-830-45-27, when the interest is received and recorded in the functional currency at the spot rate on that date, the unrealized foreign currency gain or loss should be reclassified as realized foreign currency gain or loss.

2.176 FASB ASC 946-830-45-30 states that recording dividends on foreign securities is often difficult because, in certain countries, entities customarily declare dividends retroactively, or there is a lack of timely information. Additionally, in some countries, the sequencing of the declaration date and ex-dividend date may be different from the sequencing of these dates in the United States, thus necessitating a modification of the practice of recording dividends on the ex-dividend date (see paragraph 2.112). Also, foreign entities often declare stock dividends instead of cash dividends or take other corporate actions, such as issuing rights or warrants.

2.177 The SEC staff has stated that delayed recording of foreign corporate actions may be acceptable for registered investment companies if the investment company, exercising reasonable diligence, did not know that the corporate action had occurred; in such event, the investment company should record the action promptly after receipt of the information.⁵¹

2.178 Amortization. FASB ASC 946-830-45-28 states that amortization of premiums and accretion of discounts on bonds should be calculated daily in the foreign currency. The resulting amount of income or offset to income should be translated into the functional currency using that day’s spot rate. The same foreign currency amount should be recorded as an addition to cost for accretion of discounts and a reduction to cost for amortization of premiums. Accordingly, cost consists of the original cost, translated at the spot rate in effect on the trade date that the bond was bought, adjusted for discount accretion or premium amortization at the spot rate on the date of adjustment. As stated in FASB ASC 946-830-45-25 (see paragraph 2.173), use of a weekly or monthly average rate may be appropriate in certain circumstances.

2.179 As discussed in FASB ASC 946-830-45-29, on maturity, the carrying cost (including accretion or amortization) of the security in the foreign currency equals the proceeds. However, this will not be the case in the functional currency. The original cost should be translated into the functional currency at the spot rate on the trade purchase date, and the accretion or amortization is translated at periodic spot rates. The proceeds should be translated into the functional currency at the spot rate on the maturity date. The difference between the proceeds and the accumulated cost in the functional currency is realized foreign currency gain or loss.

2.180 Withholding tax. As explained in FASB ASC 946-830-05-3, dividends and interest received from foreign investments may result in withholding taxes and other taxes imposed by foreign countries, usually at rates from 10 percent to 35 percent. Tax treaties between certain countries and the United States may reduce or eliminate such taxes. According to FASB ASC 946-830-45-33, many foreign countries do not tax capital gains on investments by foreign investors; however, if such gains are taxable, an accrual for capital gains taxes payable on both realized and unrealized gains should be included in the net asset value per share calculation.

2.181 The auditor should review the collectability of recorded receivables if withholding taxes have been reclaimed. FASB ASC 946-830-45-34 explains that whenever tax is to be withheld from investment income at the source, the amounts to be withheld that are not reclaimable should be accrued at the same time as the related income on each income recognition date if the tax rate is fixed and known. If a tax withheld is reclaimable from the local tax authorities, the tax should be recorded as a receivable, not an expense. When the investment income is received net of the tax withheld, a separate realized foreign currency gain or loss should be computed on the gross income receivable and the accrued tax expense. If the tax rate is not known or estimable, such expense or receivable should be recorded on the date that the net amount is received; accordingly, there would be no foreign currency gain or loss. However, if a receivable is recorded, there may be a foreign currency gain or loss through the date such receivable is collected.

2.182 FASB ASC 946-830-45-39 states that taxes withheld that are not reclaimable on foreign source income should be deducted from the relevant income item and shown either parenthetically or as a separate contra item in the “Income” section of the statement of operations. Taxes levied on the aggregate income or capital gains of the investment company itself should be presented in a manner that is similar to that used for income taxes. The normal withholding taxes should be presented as follows.

See paragraph 7.224 of this guide for an illustrative disclosure of the first method.

2.183 Expenses. FASB ASC 946-830-45-35 states that the accounting for expenses payable in a foreign currency is identical to that for investment income receivable in a foreign currency. An expense should be accrued as incurred and translated into the functional currency at the spot rate each day. The use of an average weekly or monthly foreign currency rate would be acceptable if the foreign currency rate does not fluctuate significantly. The related accrued expense balance should be accumulated in the foreign currency and translated into the functional currency daily, using the spot rate for that date. The difference between the expense accrued in the functional currency and the related foreign currency accrued expense balance translated into the functional currency at the valuation date spot rate is unrealized foreign currency gain or loss. When the expense is paid, the unrealized foreign currency gain or loss should be reclassified as realized foreign currency gain or loss.

2.184 Safekeeping of foreign assets. Investing in foreign securities often involves custodial or subcustodial agreements with U.S. banks and their foreign branches, as well as foreign banks and trust entities, for the safekeeping of fund assets held outside the United States. Rule 17f-5 of the 1940 Act permits registered investment companies to maintain their foreign securities with eligible foreign custodians (for example, foreign banks and trust entities that meet certain requirements, securities depositories, and clearing agencies). Rule 17f-5 sets forth the conditions that must be included in the foreign custody agreement, as well as the specific responsibilities of the investment company’s board of directors or trustees in reviewing and approving the arrangements. Additionally, Rule 17f-7 establishes conditions under which an investment company may place its assets in the custody of a foreign central securities depository.