Mutual fund disclosure update January 21, 2014

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Today’s presenters

► Bob Mulhall, Partner ► Adeel Jivraj, Partner ► Matt Forstenhausler, Partner ► Rob Meiner, Partner

Mutual fund disclosure update

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Agenda

Mutual Fund Disclosures:

► PCAOB proposal on auditor reporting model ► Tax disclosures ► Balance sheet offset – disclosures about offsetting assets and

liabilities ► Fair value measurements and disclosures

Mutual fund disclosure update

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PCAOB proposal on auditor reporting model

What information would be new?

Auditor independence and tenure

Responsibilities for footnotes and risk of material misstatement due to fraud

Responsibilities for, and results of, auditor’s evaluation of information outside of the financial statements

Critical audit matters

Current “pass/fail” model would stay the same

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PCAOB proposal on auditor reporting model (cont.)

Critical audit matters (CAMs): ► Matters involving most difficult, subjective or complex judgements ► Posed most difficulty in obtaining sufficient appropriate evidence ► Posed most difficulty in forming an opinion on the financial statements

Audit report would identify CAMs and: ► Considerations that led to that determination ► Relevant financial statement accounts or disclosures

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PCAOB proposal on auditor reporting model (cont.)

Considerations ► Disclosure of auditor tenure

► Determined at the individual fund level, registrant level or overall complex level?

► Evaluation of information outside of the financial statements ► Management’s discussion of fund performance ► Expense example ► Form N-CSR disclosures

► CAMs ► Subjectivity in determination of CAMs ► Lack of consistency in reported CAMs could create investor

misunderstanding ► Increase in audit effort and cost

Comments were due December 11, 2013 Mutual fund disclosure update

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Return of Capital Statement of Position 93-2

► Intended to provide guidance on financial reporting by investment companies for distributions to shareholders, including returns of capital

► Presentation of the retained earnings of the fund on a tax basis ► undistributed net investment income ► accumulated undistributed realized gain/loss

“What would the shareholders receive as a distribution if the fund were to liquidate?”

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ROC-SOP adjustments – key concepts

► ROC-SOP adjustments are reclass entries between the following components of capital: ► Paid in capital ► Undistributed net investment income ► Undistributed net realized

► ROC-SOP adjustments do not affect net assets

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ROC SOP (cont’d)

► Under SOP 93-2 and the Audit Guide, a reclassification is made between the composition of net asset accounts for the permanent differences, not for the temporary differences

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ROC SOP (cont’d)

► SOP 93-2 requires an understanding of permanent vs. temporary book-to-tax differences

► Sample permanent differences: ► Reclassification between income and gains

► Foreign currency gains/losses ► Paydown gains/losses ► Distribution redesignations ► NOL offset with STCG ► Basis adjustments on PFIC sales

► CLCO expired ► Nondeductible expenses ► NOL’s ► Tax return of capital distributions

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ROC SOP (cont’d)

► Sample temporary differences ► Wash sales ► Straddle loss deferrals ► PFIC mark-to-market ► IRC § 1256 mark-to-market ► Post-October/ late year ordinary losses ► Dividends Payable

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Financial statement disclosures

► Status of the fund as a regulated investment company ► Example disclosure:

The Fund intends to qualify as a regulated investment company, to distribute substantially all of its income and to comply with the other requirements of the Internal Revenue Code applicable to regulated investment companies. Accordingly, no provision for federal income taxes is required. In addition, by distributing during each calendar year substantially all of its net investment income, net realized capital gains and certain other amounts, if any, the Fund intends not to be subject to a federal excise tax.

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Financial statement disclosures (cont.)

► Cost of investments for federal income tax purposes ► Gross appreciation, gross depreciation and net appreciation on

a tax basis ► Significant book-tax differences:

► Disclose effect on components of net assets ► Example disclosure:

To reflect reclassifications arising from permanent “book/tax” differences for the year ended October 31, 20XX, undistributed net investment income was decreased by $41,000, undistributed net realized gain was increased by $30,000 and additional paid in capital was increased by $11,000. These differences are primarily due to return of capital adjustments from real estate investment trusts and net operating losses. These reclassifications had no effect on net assets.

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Financial statement disclosures (cont.)

► Tax character of distributions ► Disclose the tax basis components of dividends paid:

► Ordinary income ► Tax-exempt income ► Long-term capital gain ► Tax return of capital

► Short-term capital gain distributions will be reflected as distributions from ordinary income

► The total tax basis distributions should generally agree to the total book basis distributions as shown on the statement of changes

► Both P/Y as well as C/Y information should be presented

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Financial statement disclosures (cont.)

► Tax basis components of distributable earnings /(deficit) ► Undistributed ordinary income ► Undistributed tax-exempt income ► Undistributed long-term gain ► Unrealized appreciation/depreciation ► Accumulated Realized Capital and other Losses ► Example disclosure

► At October 31, 20XX, the components of accumulated earnings/(deficit) on a tax basis were as follows: ► Undistributed ordinary income $1,020,599 ► Undistributed long-term capital gains 441,226 ► Accumulated realized capital and other losses <12,062,595> ► Net unrealized appreciation of investment 31,430,615 ► Total accumulated earnings $20,829,845

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Financial statement disclosures (cont.)

► Capital loss carry forward (CLCF) ► Prior to RIC Modernization Act of 2010

► Capital losses — RIC’s were allowed to carryover accumulated capital losses for a period up to 8 years

► Ordinary losses — No carryover provisions were allowed. Ordinary losses may be offset against short term gains, but otherwise may need to be written off against capital

► Post RIC Modernization Act (new provisions apply to net capital losses for taxable years beginning after December 22, 2010) ► Capital losses — may be carried forward indefinitely (no limit on # of

years) ► Capital losses retain their character (ST/LT) and are deemed to

arise on the first day of the next tax year ► Losses without expiration must be utilized before old carryovers

can be used

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Financial statement disclosures (cont.)

Mutual fund disclosure update

► Late year loss deferrals

Example disclosure:

In accordance with US Treasury regulations, the Fund has incurred and elected to defer the following post-October capital losses incurred after October 31, 20XX. Such losses are treated for tax purposes as arising on November 1, 20XX; furthermore, the fund has incurred and elected to defer the following qualified late year ordinary losses incurred after December 31, 20XX. Such losses are treated as arising on January 1, 20XX. Qualified ST Capital LT Capital Ordinary losses Losses Losses___ $86,000 $2,000 $1,000

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Financial statement disclosures (cont.)

► Accounting for uncertainty in income taxes (ASC 740) Example disclosure: As of and during the period ended October 31, 20XX, the Fund did not have any liabilities for any unrecognized tax benefits. The Fund recognizes interest and penalties, if any, related to unrecognized tax benefits as income tax expense in the Statement of Operations. During the period, the Fund did not incur any interest or penalties.

Each of the tax years in the four year period ended October 31, 20XX, remains subject to examination by the Internal Revenue Service and state taxing authorities.

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Disclosures about offsetting assets and liabilities

► New reporting requirements aimed to bridge the gap between US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS)

► IASB and FASB initially issued a joint exposure draft, but decided to pursue different approaches

► IFRS: Requires entities to present separately recognized financial assets and recognized liabilities at gross amounts in balance sheet and therefore treat offsetting as exception ► Entity must offset its financial assets and financial liabilities in its

balance sheet when it intends to offset and has legally enforceable right to do so in the normal course of business, default and bankruptcy

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► US GAAP: Provides a further exception for offsetting ► Permits an entity to offset its derivative assets and liabilities in

balance sheet if there is an agreement to offset, even if that right of offset is only available in the case of bankruptcy or default

► In December 2011, FASB issued ASU 2011-11: Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities, which was clarified by ASU 2013-01. ► Effective for periods beginning on or after January 1, 2013 ► Applied retrospectively (i.e., for all periods presented on the

balance sheet)

► Does not require a change to balance sheet presentation; impact is to the notes to the financial statements

Disclosures about offsetting assets and liabilities (cont.)

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Disclosures about offsetting assets and liabilities (cont.)

► New disclosures required for: ► Derivatives accounted for in accordance with Topic 815 (including

bifurcated embedded derivatives) ► Sale and repurchase agreements and reverse sale and repurchase

agreements ► Securities borrowing and lending arrangements

► Applies to above transactions that are: ► Offset on the balance sheet in accordance with offsetting guidance ► Subject to enforceable master netting arrangements or similar

agreements regardless of whether or not they are presented in accordance with offsetting guidance

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Disclosures about offsetting assets and liabilities (cont.)

► Information to enable users to evaluate the effect or potential effect of netting arrangements of an entity:

1. Gross amounts of assets and liabilities 2. Amounts offset in the balance sheet 3. Net amounts 4. Amounts subject to a netting arrangement not included in #2 (i.e.,

collateral or positions not offset) 5. Remaining net amount

► Assets and liabilities separately presented in tabular format

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Disclosures about offsetting assets and liabilities (cont.)

Mutual fund disclosure update

► Example disclosure – direct from 210-20-55-20

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Disclosures about offsetting assets and liabilities (cont.)

► Column iii–v may be presented by counterparty

► Disclosure of counterparty legal name not required ► Insignificant counterparties grouped in “other”

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Disclosures about offsetting assets and liabilities (cont.) ► Disaggregation for sophisticated entities with significant

derivative activity

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Fair value measurements and disclosures ► ASC Topic 820 Fair value measurement (formerly FAS 157)

► Effective for fiscal years beginning after November 15, 2007

► Defines fair value and provides a framework for measuring fair value

► Requires disclosures about fair value measurements ► Fair value hierarchy

► Level 1 – Quoted prices in active markets for identical assets/liabilities Level 2 – Significant unobservable inputs

► Level 3 – Significant unobservable inputs ► For Level 3 measurements, the effect on earnings (or

changes in net assets) for the period

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► ASU 2011-04 – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs ► Effective for fiscal years beginning after December 15, 2011

► Significant amendments: ► For Level 3 fair value measurements, disclosure requirements:

► Quantitative information about the significant unobservable inputs used in the valuation of Level 3 measurements (tabular format)

► Description of valuation processes surrounding Level 3 measurements

Fair value measurements and disclosures (cont.)

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Quantitative information about Level 3 fair value measurements($ in millions)

Fair value at 12/31/X9 Valuation technique(s) Unobservable input Range (weighted average)

Residential mortgage-backed securities 125 Discounted cash flow constant prepayment rate 3.5% - 5.5% (4.5%)probability of default 5% - 50% (10%)

loss severity 40% - 100% (60%)

Commercial mortgage-backed securities 50 Discounted cash flow constant prepayment rate 3.0% - 5.0% (4.1%)probability of default 2% - 25% (5%)

loss severity 10% - 50% (20%)

Collateralised debt obligations 35 Consensus pricing offered quotes 20 - 45comparability adjustments (%) -10% - +15% (+5%)

Venture capital investments: healthcare 53 Discounted cash flow weighted average cost of capital 7% - 16% (12.1%)long-term revenue growth rate 2% - 5% (4.2%)

long-term pre-tax operating margin 3% - 20% (10.3%)

discount for lack of marketability(a) 5% - 20% (17%)

control premium(a) 10% - 30% (20%)Market comparable companies EBITDA multiple(b) 10 - 13 (11.3)

revenue multiple(b) 1.5 - 2.0 (1.7)

discount for lack of marketability(a) 5% - 20% (17%)

control premium(a) 10% - 30% (20%)

Venture capital investments: energy 32 Discounted cash flow weighted average cost of capital 8% - 12% (11.1%)long-term revenue growth rate 3% - 5.5% (4.2%)

long-term pre-tax operating margin 7.5% - 13% (9.2%)

discount for lack of marketability(a) 5% - 20% (10%)

control premium(a) 10% - 20% (12%)Market comparable companies EBITDA multiple(b) 6.5 - 12 (9.5)

revenue multiple(b) 1.0 - 3.0 (2.0)

discount for lack of marketability(a) 5% - 20% (10%)

control premium(a) 10% - 20% (12%)

Credit contracts 38 Option model annualised volatility of credit(c) 10% - 20%

counterparty credit risk(d) 0.5% - 3.5%

own credit risk(d) 0.3% - 2.0%

(a) Represents amounts used when the reporting entity has determined that market participants would take these premiums and discounts into account in a fair value measurement.(b) Represents amounts used when the reporting entity has determined that market participants would use such multiples when measuring the fair value of these investments.(c) Represents the range of the volatility curves used in the valuation analysis that the reporting entity has determined market participants would use when measuring the fair value of these contracts.(d) Represents the range of the credit default swap spread curves used in the valuation analysis that the reporting entity has determined market participants would use when measuring the fair value of these contracts.

(Note: For liabilities, a similar table should be presented.)

Fair value measurements and disclosures (cont.)

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► Description of valuation processes surrounding Level 3 measurements ► Description of the group responsible for valuation policies and procedures, to whom that group

reports, and the internal reporting procedures in place (e.g., how pricing, risk management, or audit committees discuss and assess the fair value measurements)

► Frequency and methods for calibration, back testing and other testing procedures of pricing models

► Process for analyzing changes in fair value measurements from period to period ► Methods used to develop and substantiate the unobservable inputs used in a fair value

measurement

► Narrative description of the sensitivity of recurring Level 3 measurements to changes in the unobservable inputs disclosed, including the inter-relationship between these inputs (only public companies) ► “The significant unobservable inputs used in the fair value measurement of the reporting entity’s

residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases in any of those inputs in isolation would result in a significantly lower fair value measurement. Generally, a change in the assumption used for the probability of default should be accompanied by a directionally-similar change in the assumption used for the loss severity and a directionally-opposite change in the assumption for prepayment rates.”

Fair value measurements and disclosures (cont.)

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► ASU 2011-04 significant amendments (continued): ► Public entities shall also disclose all transfers between Levels 1 and 2 (not

only significant transfers). Private companies are exempt from disclosing any information about transfers.

Fair value measurements and disclosures (cont.)

Mutual fund disclosure update