The Hindu Business Line : Fund versus corporate accounting

As we all are aware, a company's annual accounts are prepared at its financial year-end (March 31, in most cases in India). The accounts and financial statements are taken up at the board meeting and audited. The board of directors is supposed to comment on the audit report. Audited accounts are taken up at the annual general meeting (AGM) and thereafter dividend is distributed.

The law provides various deadlines relating to holding board meetings, audit and filing of annual accounts with the Registrar of Companies, such as 21 days' notice for AGM and 30 days' dividend distribution time thereafter.

More time

This way, the law allows time for disclosure of proper financial statements as of the year-end. A lag of up to one month is allowed, even for the quarterly disclosure of financial performance. In short, corporate accounting is more of regular record-keeping of transactions so that the balance-sheet can be drawn as of the required date ( year-end, for instance) for various purposes.

The concept of fund accounting relates more to valuation of asset value of a mutual fund corpus. Simply put, it includes regular accounting of transactions for arriving at its balance sheet, which can be valued to arrive at net asset value (NAV).

However, based on the purpose behind fund accounting and corporate accounting, their approaches and relative criticality differ. For a listed corporate, a shareholder can exit or an investor can enter at the listed price on the stock exchange, which is presumed to be fair market value (FMV) of shares at that point of time. This listed price, is presumed to consider:

The build-up in reserve after last available balance sheet.

Most current NAV estimate, based on the accumulated earnings of current period.

Though listed price is normally based on yield method (that is, earning per share x price-earnings ratio), it also considers the asset-pricing method. This method is partly reflected by the price or book-value ratio, which tries to capture the most current development in a company's NAV.

A listed corporate normally works as a "going concern" with a system to generate returns regularly within its own business model. Being a "running business and profit model on a going-concern basis", pricing may be higher than its NAV based on realisable value of assets (yield method may support additional premium to corporate valuation).

Being a `going concern', accounting standards relating to fixed assets, depreciation, amortisation and income recognition are accepted for true and fair disclosure of financial statement and for arriving at the FMV of company's share value.

Inventories in the corporate financial statements are normally valued at the lower of cost or realisable value. In other words, inventory, as an asset class, is meant for realisation and, hence, the concept of `realisable value' makes more sense for its valuation.

These apart, the FMV or listed price of a share, is a function of market expectations and demand-supply of stock, which is again driven by liquidity and general expectation about the company's performance.

Open-ended funds

In an open-ended mutual fund, NAV disclosures are much more frequent than disclosure of balance-sheets by a listed corporate. In mutual funds, owing to the absence of listed price, investors deposit and withdraw money frequently based on NAVs . With no listed price, the NAVs have to be worked out. In other words, there is need for much more regular balance-sheet preparation of a corpus so that NAVs can be worked out regularly. This requires much better treatment of various accounting transactions and asset valuation within each shorter period.

Further, in comparison to a corporate, the portfolio of an open-ended mutual fund doesn't have its own business model to generate income. From the perspective of the financial product, a mutual fund portfolio is a derivative of various business models in which portfolio holdings exists.

Further, an investor in an open-ended mutual fund is allowed to withdraw funds on any day and, hence, theoretically, a corpus may turn zero if all the investors withdraw the funds. Thus, an open-ended mutual fund's NAV cannot be valued on a going-concern basis. It has to be valued on a `net realisable basis' for each of the smaller period of frequency at which NAV is calculated. In other words, for each day, valuation has to be on net realisable basis. This concept may become very important in situations such as amortisation of issue expenses; write off of defaults and NPAs; and accruals of interest on `net realisable value' rather than at `contracted rate'.

Let us look at the case of a listed closed-ended mutual fund scheme. From its listed price and NAV, the following observations can be made:

Listed price is at a discount to `net realisable value'. It is not at a `premium' to support the argument of a `going concern'.

The discount, more or less, represents interest on balance period to the expiry of the closed-ended fund, as the buyer has to block his funds.

Accounting perspective

For a corporate, even if there is over- or under-recognition of income or expenditure (to be set-off in the next period), it is normally taken care of by the listed price in the market. Preliminary and issue expenses in corporate accounting are allowed to be amortised across years because;

It is a going concern; and

Listed price already takes care of reduction in reserve due to preliminary expense.

Once preliminary expenses are taken care by way of reduction in reserve for valuation of the corporate entity, it simply means that such expenses are supposed to be written off immediately to arrive at the FMV. In case of listed shares, the listed price automatically takes care of it. Listed price does not wait for set-off of under/over provision.

However, in fund accounting, as an investor can invest or exit on any day at that day's prevailing NAV, it is critical to work out the net realisable asset value of each day on a much fairer basis. Any under/over provisioning may result in irregularity in the NAV at which investors enter or exit. This makes the concept of fund accounting far more critical.

Thus, criticality of any such accounting for valuation depends on;

Whether the valuation is available though listed price.

Whether valuation is based on going concern or NAV.

The frequency at which valuation of NAV is necessary. In case of listed price, the shortest time interval will be taken care of. However, in the case of unlisted mutual fund corpus, the valuation has to be fair enough each time, whenever investors are allowed to enter or exit.

Take the example of a close-ended fund with a six-monthly exit option. Ultimately, the purpose is that on each exit option date, the NAV should be fair. In a corporate account, the listed price normally takes care of all such under/over provisioning as per the accounting standards.

To ensure that the listed price is fair and transparent, adequacy and frequency of disclosure norms by corporates become vital factors. Likewise, to ensure that the NAV is fair, fund accounting has to be based on the FMV of the net asset of the corpus.

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