One of the many appealing aspects of the ETF vehicle is that it is generally designed to be tax efficient. The primary mechanism for achieving tax efficiency is the ability to redeem appreciated securities in-kind.  Any gains realized on securities redeemed in-kind are not taxable and therefore do not need to be distributed to underlying shareholders. The ability to utilize custom baskets further enhances an ETF’s tax efficiency by redeeming a sampling of appreciated securities in redemption transactions, while selling depreciated securities to harvest losses.  A seasoned ETF is unlikely to ever have to pay a capital gain distribution.

The Coronavirus pandemic (“COVID-19”) is causing significant financial and operating hardships across all industries. Any companies that are currently preparing GAAP financial statements, including investment companies, should consider whether or not the impact of COVID-19 represents a significant event as defined in FASB Accounting Standards Codification (“FASB ASC”) 855, Subsequent Events.

April 2020 Update:

In my original post on answering the question if securities lending fees could be treated as expense offset, my answer to the question was “maybe." This was not a popular answer with my clients as they had competitors who were clearly treating the fees as expense offset.  One of our core values here at BBD is to be a collaborative partner to our clients, within the confines of our professional standards.  While we pride ourselves on being collaborative, this does not mean that we simply try to give our clients the answer that they want to hear.  A big part of being collaborative is providing accurate and correct information to our clients.  This also coincides with our second core value of being authentic. We mean what we say and we say what we mean. Our clients value hearing the truth.  In accordance with these values, I stand by the conclusion in my original post, but would like to further clarify my conclusion from “maybe” to “maybe but unlikely.”  I have yet to see a securities lending arrangement structured in a way that would support treating the fees as an expense offset.  While I believe it is conceptually possible, the most likely result will be that securities lending fees will be treated as an item of income.

On August 17, 2018, the SEC adopted what effectively amounts to “housekeeping items” for a variety of public issuers. These updates are effective November 5, 2018. 

In August 2018, the Financial Accounting Standards Board (FASB) finalized changes to fair value measurement disclosure requirements that had been under debate for several years as part of the disclosure framework project.

Today I am writing about an accounting error I have been seeing more and more while performing audits of exchange traded funds (“ETFs”).

All investment companies (“Funds”) registered under The Investment Company Act of 1940 are required to calculate and present a Total Return in their financial statements. Total Return represents the rate that an investor would have earned (or lost) on an investment in the Fund, assuming reinvestment of all dividends and distributions. Instructions for computing Total Return can be found in the SEC instructions to the Registration Statement, Form N-1A for open-end funds and Form N-2 for closed-end funds. The instructions to form N-1A require Funds to compute Total Return assuming the initial investment is made at the net asset value at the beginning of the period, distributions are reinvested at the net asset value on the ex-dividend date, and all shares are redeemed at net asset value on the last business day of the period. For closed-end funds that file registration statements on Form N-2, Total Return is calculated assuming the initial shares are purchased at the market price on the first day of the period, distributions are reinvested at prices obtained by the Fund’s dividend reinvestment plan or, if there is no plan, at the lower of the per share net asset value or the closing market price of the Fund’s shares on either the ex-dividend or distribution pay date, and all shares are sold at the market price on the last day of the reporting period.

There are several emerging markets that do not allow for in-kind transfers of securities, for example Brazil and India. Additionally, some countries, such as Brazil, impose a tax on new purchases of their currency. When units are created in ETFs that focus on these emerging markets, cash is contributed by the authorized participant (“AP”) in lieu of securities since an in-kind transfer is not possible. The ETF then uses this cash to purchase the securities requested at creation. Along with this cash in lieu, the ETF and the AP typically agree to lock in the price of the securities at the time of creation. If the price of the securities rise from the time of creation until the time the Fund is actually able to purchase the securities, the AP makes an additional cash contribution to the Fund to cover the increase in cost. If the prices decrease, the Fund returns cash to the AP. Additionally, the AP typically agrees to reimburse the Fund for costs incurred to acquire securities that were not able to be transferred in kind, such as transaction costs and taxes (i.e.Brazil currency).

It is imperative for open-end investment companies to value their investments at fair value when determining their net asset value ("NAV"). For investment companies that invest a significant portion of their investments in foreign securities, the importance of fair value is magnified. Due to different time zones, many foreign exchanges close well before the close of the U.S. markets. If significant events occur after the close of the foreign markets, but before the close of the U.S. markets, the closing price of the foreign investments will not be reflective of the current market value. This creates arbitrage opportunities for market timers. Market timers look to profit from these arbitrage opportunities and do so at the expense of the remaining shareholders of the fund. To combat market timers, most mutual funds that invest in foreign securities utilize fair value factors to adjust closing foreign prices to reflect events occurring after the close of the foreign markets but before the close of the U.S. markets. Some funds establish a threshold or trigger of movement that must occur before applying the fair value factors, but more and more funds are beginning to apply fair value factors on a zero threshold basis.

As I am starting to work with more and more Exchange Traded Funds (ETFs), it is becoming increasingly apparent that they need their own specific set of accounting and reporting rules. Currently, an ETF falls under the guise of an open-end management investment company registered under the Investment Company Act of 1940. While this classification is technically correct, there are certain rules / guidance for open-end 40 Act investment companies that really do not make sense for an ETF. One example is the method by which Total Return is required to be calculated. Another, while admittedly more debatable, is the use of fair value adjustment factors when valuing investments domiciled on foreign exchanges for the purposes of determining the daily net asset value (NAV) of the ETF.