Funds May Have to Amortize Bond Premiums
August 9, 1999
Fixed-income mutual fund companies may soon have their yields deflated if a proposed rule from the American Institute of Certified Public Accountants (AICPA) of New York becomes effective. Although the AICPA claims it is still exploring the issue, industry insiders say the AICPA has already decided to enforce the rule and is awaiting an endorsement from the Financial Accounting Standards Board.
The rule, which would become effective December 2000, would require funds to amortize premiums and accredit discounts of bonds in their distribution yields. AICPA already made amortization of municipal bonds mandatory and now wants to extend the practice to corporate and federal bonds.
Many fund companies do not reflect bond purchase prices in their distribution yields, particularly when bonds are purchased at a premium, since amortizing the premium price -- spreading it over the life of the bond -- lowers the yield a few basis points, said Burton Greenwald, a mutual fund consultant with Burton J. Greenwald of Philadelphia. Instead, mutual fund companies usually absorb purchase prices of bonds that are higher than their face value when the fund sells the bond, Greenwald explained. On the other hand, when a fund purchases a bond at discount, many times the fund will accredit that surplus in its yield, thereby increasing it.
The AICPA maintains that such inconsistent accounting tactics create artificially inflated distribution yields that can mislead investors. "A lot of fund companies amortize discounts, but not premiums, for tax purposes," said Sheila Yu, technical manager, accounting standards, at the AICPA.
The Investment Company Institute, the mutual fund trade organization in Washington, conceded in a December 1998 comment letter to the AICPA that because of different accounting procedures, "funds with substantially similar investment portfolios [may report different] levels of net investment income."
However, the ICI said mutual fund companies have not been guilty of inflating investment income and there have been no abuses of this accounting practice. Furthermore, the SEC requires any fund company advertising a yield to calculate that yield by amortizing the premium and accrediting the discount, much the same way the AICPA now proposes.
The ICI also contended that the SEC already adequately oversees the accounting practices of mutual fund companies and does not need any additional regulations from the AICPA.
But the ICI did not stop there. The group also said it opposed the rule because it would apply only to a fund company's books and not its tax documents. Even if a fund company conscientiously tried to match its book and tax valuations, there would be discrepancies because tax amortization methods vary for different securities.
In addition, AICPA's rule would require a fund adviser to separately report losses from investments in securities not in line with the fund's investment strategy. Fund advisors currently report such losses on a consolidated income statement, but are not required to do so, much less reimburse funds for such losses, the ICI said. If the AICPA began requiring advisers to separately report losses for ill-aligned investments, advisers will resist calling attention to their mistakes and stop reporting them altogether -- along with reimbursements, the ICI said.
But not all fund companies agree with the ICI. Diana Herrmann, president and chief operating officer of Aquila Management Corp. of New York, a fund company that specializes in regional, fixed-income funds, is not opposed to AICPA's proposed rule because, she said, most fund companies already amortize premiums to reflect accurate prices.