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Mutual funds: it's time for better reporting.

Financial accounting deals with extraordinarily complex issues, but its purpose is quite simple: to communicate economic reality. The accounting profession's body of knowledge generally accepted accounting principles--permits dissimilar organizations to apply the same standards in presenting financial results. The performance of businesses as dissimilar as banks, factories and hospitals can be compared consistently from one period to the next.

Because GAAP financial statements have significant predictive value, interested parties can track trends in sales or revenues, dividends, retained earnings and book values. In one area, however, GAAP is ineffective for the principal end users of financial information. These accounting principles, developed for companies with financial statements based on historical cost accounting, should not be applied to mutual funds. GAAP statements do not depict economic reality for mutual funds; funds operate primarily on a market value and tax basis and shareholders would be better served by a different financial reporting approach. In the square peg in a round hole analogy, mutual funds are the square peg and GAAP is the round hole.

There is a square hole mutual funds fit into naturally: tax-basis accounting. It's time to modify GAAP significantly for mutual funds and account for their income exclusively on a tax basis. A substantial majority of mutual fund financial executives say preparing tax-basis financial statements for mutual funds would provide many advantages over GAAP. Almost three-quarters of the financial executives in the mutual fund industry surveyed in 1992 by the Investment Company Institute said switching to tax-basiS reporting would provide shareholders with more meaningful financial statements.

Furthermore, the American Institute of CPAs, the Securities and Exchange Commission and the Financial Accounting Standards Board already have recognized the importance of applying elements of tax-basis accounting to mutual funds. The AICPA and the FASB recently endorsed basing mutual funds' return-of-capital distributions reporting solely on tax rules. SEC rules regulate long-term capital gain distributions, exclusively a tax concept. However, these bodies have stopped well short of endorsing a complete change to tax-basis reporting.

Tax-basis reporting would give shareholders the information they want and need in a clear, understandable format. A wide array of book-tax differences would be eliminated. There would be a single, consistent basis for mutual fund accounting instead of two often contradictory and misleading bases.


Open-end investment companies--or mutual funds--hardly resemble companies that produce goods or services. Depending on their investment objectives, funds can be made up of listed or unlisted common stocks; money market instruments; foreign securities; government, corporate or municipal bonds; or other securities. Most funds are organized as corporations but also may be limited partnerships or business trusts.

Mutual funds are pools of securities that provide investors with diversification, professional management and convenience. They have existed in the United States since 1924. Most of the current accounting rules date to the Investment Company Act of 1940, which mandated SEC registration and recognized the public expected mutual funds to be exempt from federal income tax at the corporate level.

Mutual funds are creations of the tax law; without special tax treatment, few if any could exist. When funds meet certain requirements, federal income taxes on earnings are paid by shareholders only on distributions received from such earnings. Mutual funds thus are tax conduits not subject to the double taxation of companies producing goods or services. Conduit status makes funds attractive investments for individual investors, large and small.

Until the 1980s, mutual funds were fairly simple. They invested in stocks, bonds and money market instruments; few complex securities or techniques were used or even existed. But the last decade saw an explosion of new, complex techniques and security-like investments such as options, futures, zero-coupon bonds, asset-backed securities and junk bonds. In one frenetic year, an estimated 130 new types of instruments were brought to market. As mutual funds began to invest in these instruments and to use more sophisticated techniques, tax accounting became more complex. Tax law changes compounded the complexity. A dozen years ago a single individual could handle the tax accounting for several fund families; today, it takes a well-staffed department of experienced accountants to provide similar services.

Before the Tax Reform Act of 1986, funds could (and did) wait until the calendar year following the end of their fiscal year to pay short- and long-term capital gains and often dividends from net investment income. But under the TRA, to avoid a nondeductible 4% excise tax, mutual funds must by December 31 each year distribute at least 98% of

* Any net tax-basis capital gains earned through October 31.

* Tax-basis ordinary income earned through December 31.

Thus, most of the tax-planning process for fund portfolio managers and treasurers has been placed on a calendar-year basis and compressed to two months. To avoid federal income tax, funds also must distribute at least 90% of their fiscal-year taxable income, net capital gains and net tax-exempt income by the time they file their federal income tax returns.

Shareholders now face the same tax planning crunch. Previously, investors had up to one and a half year's warning of their tax liability. Now, as a result of the TRA distribution requirements, they find out after December 31, when it's too late to do anything. Most investors have little or no idea of the taxable income generated by the mutual funds they own until they receive form 1099 at the end of the following January. Further, it is not clear to investors how much of the fund's actions are driven by its own tax needs, which change yearly. This means major effects of tax law changes are hidden from investors, who bear the cost.


In the 1980s, GAAP and tax accounting for mutual funds diverged markedly. Previously, book-tax differences were minor and relatively simple to understand. Before the 1980s tax law changes, investment income was mostly on an accrual basis for book purposes, with few cash-basis adjustments for tax purposes. Now the accrual basis for book purposes contrasts with mark-to-market taxability of Internal Revenue code section 1256 contracts, treatment of currency gain or loss as interest income or expense and other novel tax law changes. Additionally, wash-sale adjustments create book-tax differences, as they always have, but such differences occur more often.

Because of tax law changes and the evolution of new securities and techniques such as indexing and short sales, at least 21 areas, listed in the exhibit on page 69, present significant potential book-tax differences. Because these differences are so pervasive, fund financial statements using GAAP often give shareholders little warning of the tax liabilities likely to result from their investments. A few of the most important areas of divergence are discussed below.

Government National Mortgage Association and Federal National Mortgage Association prepayments. Mortgage-backed securities have become enormously popular and billions of dollars have flooded into mutual funds that invest in them. When a GNMA or FNMA security bought at a premium is prepaid at par value, most of the difference shows up on the books as a capital loss. But there usually is little or no tax loss; instead, the loss is treated as an adjustment to ordinary income for tax purposes.

Interest accruals on defaulted or troubled securities. Junk bond funds attracted huge amounts of investor capital in the 1980s. In a weak economy, defaults are more common. For hook purposes, funds often immediately stop accruing interest upon default of a coupon payment. For tax purposes, interest accruals must continue until all hope of collection is gone. Unless there is hard evidence, such as a court order, this is not a clear-cut matter. In some cases, phantom interest must be accrued for an extended period. Current GAAP does not communicate this clearly.

Section 1256 contracts. These are contracts for future delivery of certain commodities (including financial futures) that must be marked to market at yearend, with a resulting tax-basis capital gain or loss. The tax cost basis is then adjusted accordingly. On the books, the gain or loss is still unrealized, without any impact on retained earnings. Assuming there is a tax-basis gain, a distribution must be made.

Where does the distribution come from for book purposes, and how can it be shown logically? One possibility is to put the debit in the unrealized gain section of the financial statement. However, several reporting principles seem to be compromised when these distributions occur. Tax-basis accounting would avoid such violations of basic accounting principles.

Capital loss carryforwards. This is a timing issue that can result in significant book-tax differences. For book purposes, capital losses are reported in the year incurred. However, excess capital losses are not immediately deductible and cannot be carried back. They may be carried forward for eight years to offset capital gains. When carry forwards are used, a book-tax difference results; a different book-tax difference results when carry overs expire.

Straddles. Straddle rules are one of the most difficult areas of the tax law. Previously, investors used straddles to create immediate deductible tax losses without a current economic loss. Under new tax rules, a tax loss on a straddle cannot be deducted until the open offsetting gain position also is sold. However, the open gain position might be carried on the tax books at market value, creating a further book-tax difference.


Tax reform has changed shareholders' tax situations dramatically. By virtually eliminating preferential treatment for longterm capital gains, current tax law makes almost all distributions fully taxable at ordinary income rates. Fund investors usually are in the 28% or 31% tax bracket. Most states also impose income taxes, so shareholders can lose a third or more of their distributions to taxes. Tax considerations for mutual fund investors are thus extremely important but not easily communicated to shareholders, as the following example suggests.

Gordon bought an equity fund at $10 per share in January 1991. An ordinary income dividend and a long-term capital gain distribution totaling $1 per share were paid in December 1991. (Dividends and short-term gains are lumped together for this purpose.) By December 31, the share price had risen to $12, so Gordon's total return for the year was 30% ([$10 + $2 + $1 = $13] $10 starting investment = $3, a 30% gain).

In January 1992, Gordon received a statement from the fund, followed by a form 1099. Only then did he know for sure taxes of about $.30 were owed on the $1 distribution, so the net return was really 27%. If Gordon had received a distribution of $2 per share and the unrealized gain had been $1, the 30% pretax return would have been 24% and he would owe $.60 in taxes on each fund share--a significant reduction in return.

Meanwhile, Gordon received semiannual financial statements from the fund listing portfolio securities and their current values. (This is useful information, although it may be dated by the time investors receive it.) However, the fund's income, gain and distribution statements were all calculated using GAAP, possibly obscuring what most fund investors need to know: taxable income for the year.

Because investors cannot determine one of their basic needs from the statements, they call the fund or their broker. Except for routine matters such as purchases and redemptions, tax questions are the most common reason for shareholder calls to mutual funds (and to fund treasurers in particular).

The SEC is pressing the mutual fund industry to adopt single allowable accounting principles for many problem areas. Although the merits of this inflexible approach to adopting accounting principles are debatable, preparing mutual fund statements on a tax basis would readily meet the SEC's demands.

Maintaining consistency is a major reason for continuing to follow GAAP. Tax laws and regulations change. Critics claim tax-basis statements would introduce inconsistency. That may be true, but absolute comparability cannot be attained in mutual fund accounting. Portfolios change constantly as investors buy and sell shares, fund managers buy and sell securities and the securities held are marked to an everchanging market.

Because absolute year-to-year consistency of underlying securities is not possible and total returns based on market value would not change at all, the consistency standard has no predictive value for mutual funds. As mentioned earlier, mutual funds, as investment pools, are not like operating companies for which the consistent application of accounting principles is vital to discerning underlying earnings trends.

For mutual funds, only total return statistics can be used as a reliable trend indicator. Major swings in outstanding shares (caused by subscriptions and redemptions) affect the elements of a fund's year-to-year total return (since the shares are sold only at market value including the value of interest income earned).


The first step in producing tax-basis financial statements would be to convert mutual fund income statements to tax basis. Essentially, the current page one of form 1120-RIC would be reported to shareholders. (Form 1120-RIC is the annual tax return for regulated investment companies. Page one of the form summarizes revenue, expenses and investment-company taxable net income.)

Because net assets still must be reported at market value, little if any of the portfolio presentation, statement of net assets and the per-share table would need to change. Retained earnings on the statement of net assets would be converted to tax basis, as would all distributions shown on the statement of changes in net assets and in the per-share table.

Portfolio holdings would be presented as they are currently, but only the tax-basis cost would be shown. One proposal under development suggests putting tax-basis adjustments in the footnote. It makes more sense to put GAAP-basis adjustments in a footnote, if needed. The statement of net assets would be presented similarly, but it would show tax-basis earnings and profits instead of two retained earnings accounts. The statement of operations would look much like page one of form 1120-RIC; the statement of changes in net assets would look like the form's schedule M-2, which reconciles retained earnings on a book basis from year to year.

Overall, tax-basis financial statements would not look radically different from current GAAP statements. However, the additional information they would contain (such as tax-basis ordinary income and long-term capital gains) would be far more useful to shareholders. By reading quarterly or semiannual statements, shareholders could make informed judgments about their tax liabilities and plan accordingly.


Tax-basis statements would make life easier for CPAs providing tax advice to clients and enable them to give more effective counsel. One basis of accounting would help reduce the shareholder confusion and might even reduce costs. CPAs are understandably reluctant to make exceptions to the principles that have served their profession so well. But because of substantial tax law changes, those principles do not do justice to mutual funds. It's time for all concerned with mutual funds to look at the issues with open minds, keeping the real needs of shareholders foremost.

* GENERALLY ACCEPTED accounting principles are ineffective in communicating financial information about mutual funds. Fund investors would be better served by financial statements prepared on a tax basis.

* TAX-BASIS REPORTING would give mutual fund shareholders the information they need in an understandable format. Tax-basis financial statements would be particularly helpful to shareholders when doing tax planning.

* THE DIFFERENCES BETWEEN GAAP and tax-basis reporting have grown since the 1980s as a result of myriad tax law changes and the advent of new securities and investment techniques.

* BECAUSE MUTUAL FUND investment holdings change from year to year, the consistency offered by GAAP financial statements is of no real benefit to investors. Since mutual funds are not operating companies, applying consistent accounting principles is not vital to discerning underlying trends.

* TAX-BASIS FINANCIAL statements for mutual funds would make life much easier for CPAs providing tax advice to clients, as well as for mutual fund companies themselves, which have seen their accounting staffs grow in recent years.

Significant potential book-tax differences

* Wash sales.

* Market discounts.

* Bond premiums.

* Interest accruals on defaulted or troubled securities.

* Specific identifications of securities sold.

* Capital loss carryforwards.

* Section 1256 contracts.

* Straddles.

* Short sales.

* Internal Revenue Code section 988 foreign currency transactions.

* Passive foreign investment companies.

* Foreign taxes paid.

* Partnership investments.

* Nontaxable distributions.

* Government National Mortgage Association-Federal National Mortgage Association repayment gains and losses.

* Nondeductible excise taxes.

* Post-October capital-currency losses.

* Gross income requirements.

* Returns of capital distributions paid.

* Complex securities.

* Original issue discounts.
COPYRIGHT 1993 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Nave, Vincent
Publication:Journal of Accountancy
Date:Jul 1, 1993
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