Sign up today and take advantage of member-only content — the kind of timely, cutting edge industry insight that only Money Management Executive can deliver.
  • Exclusive Online Only Content
  • Free Daily Email News Alerts
  • Asset Management Blogs

Accounting Reinterpretation Vexes Funds

Since late 2006, fund executives have been fretting over a past accounting treatment and reinterpretation of an accounting standard for municipal bond funds.

At issue is the accounting treatment for a widely used complex derivative security known as an "inverse floater." Inverse floaters are fixed-income securities that are structured through the selling of a fixed-rate municipal bond to a specially created financial vehicle known as a tender option bond trust. The trust then issues variable, or floating, rate notes to third parties. These notes are collateralized by the fixed-rate bonds, and the fund manager typically purchases an interest in the trust and its cash flows. The variable return on an inverse floater is tied to a specific floating-rate index and fluctuates.

This change may or may not be considered, according to accounting standards, a "material" change. If deemed large enough to be material, fund groups will have to restate and correct their financial statements and past comparative year's highlight data-an initiative that has many worrying that shareholder lawsuits will result, although shareholders won't be financially impacted.

Root of the Problem

At the root of the problem is accounting rule FAS 140 that the Financial Accounting Standards Board first prescribed in 2000. The rule, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, lays out the accounting for securities such as inverse floaters.

When a portfolio manager sells a fixed-rate municipal bond to that specially created trust, the transaction, at least on paper, looks like a simple security sale, explained Larry Friend, a consultant to the investment management industry, former partner with PricewaterhouseCoopers and former chief accountant for the Securities and Exchange Commission's division of investment management.

But if this is a transaction where a manager may take the bond back, such as with an inverse floater, then the transaction is not a true sale, but a security lending transaction, Friend said.

Under accounting rule FAS 140, when a security such as an inverse floater is involved, the fund's balance sheet should reflect an increase in both the fund's assets and an equivalent increase in the fund's liabilities. This is known as "grossing up" the balance sheet.

The net effect is that the added asset and liability cancel each other out. There's no change to the fund's bottom line net income, or return to investors. Up until late last year, this was not being done by fund accounting departments.

But here's the key difference, Friend added. "If funds gross up assets and liabilities, they must also gross up income and expenses, and there's a question as to whether the interest expense should be netted out against the income derived from the asset."

If fund accountants take the conservative approach, that interest gets added to a fund's expenses and each municipal bond fund's expenses will be inflated, Friend explained.

The fear is that investors may balk at those higher expenses and sue, charging that they wouldn't have invested in the fund had they known of the true expenses, industry executives said.

Near the end of 2006, as fund annual reports were being prepared, auditors questioned, then reviewed, the proper treatment of inverse floater transactions. At that time, several fund groups huddled with their auditors to discuss these inverse floaters and what to do accounting-wise. Some fund groups, including AllianceBernstein, BlackRock, Goldman Sachs and Morgan Stanley, delayed filing their funds' annual reports with the SEC. Others filed notices to investors about the changes, and several groups have since filed amended annual statements with corrections and enhanced information.

"Virtually every fund group that manages a municipal bond fund and invests in inverse floaters was impacted," an industry insider said.

"Eaton Vance, and much of the municipal income fund industry, has been using inverse floaters for over 13 years," said an Eaton Vance spokeswoman in a statement. "Recently, our long-time auditors proposed to [us], and to Eaton Vance's knowledge, to all the auditor's clients whose funds hold similar investments, that the presentation in the funds' financial statements should be revised. The change had no effect on the funds' current or historical net asset value or current or historical income payments to the funds' shareholders."

DWS Scudder, the mutual fund unit of Deutsche Bank, restated its funds' annual report on Feb. 26 and enhanced the language describing inverse floaters, noting that, "these transactions are considered a form of financing for accounting purposes. As a result, the fund includes the original transferred bond and a corresponding liability equal to the floating rate note issued."

"Evergreen Municipal Bond Fund has invested and continues to invest in [inverse floaters], resulting in a need to restate its annual report as of May 31, 2006, including the financial highlights for the prior five years, to reflect the impact of the change in accounting treatment for inverse floaters," the firm noted in a statement issued to MME.

"We're monitoring the situation carefully. We've had conversations with our members," said a spokesman with the Investment Company Institute.

Six accounting firms that provide audit services to the mutual fund industry, including the Big Four-Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers-either declined to comment or had not responded to a request for comment.

Interest rate sensitive inverse floaters first came to prominence in 1994 and 1995 when a series of interest rate hikes by the Federal Reserve caused the values of these securities to tank, catching several fund managers unaware as to their true sensitivity. Lawsuits and disciplinary actions from the SEC and NASD followed, charging fund groups with not properly disclosing these investments and their potential risks.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.