Audit and Attest Issues

1. The Department of Labor (DOL) issued a final rule on October 25, 2011, that became effective December 27, 2011, which revised the Pension Protection Act of 2006 to make investment advice more accessible for those who have investments in 401(k) plans and IRAs. The revision now allows fiduciary advisers to receive compensation from investment vehicles they recommend if either (1) the investment advice they provide is based on a computer model certified as unbiased and as applying generally accepted investment theories, or (2) the adviser is compensated on a "level-fee" basis (i.e., fees do not vary based on investments selected by the participant). The rule identifies circumstances where an annual “audit”

needs to be performed in order for an adviser to meet the exemption. Areas to be covered in the audit include determining that (emphasis added):

 Any investment advice is based on generally accepted investment theories that take into account the historic risks and returns of different asset classes over defined periods of time;

 Any investment advice takes into account investment management and other fees and expenses attendant to the recommended investments;

 Any investment advice takes into account information relating to age, time horizons (e.g., life expectancy, retirement age), risk tolerance, current investments in designated investment options, other assets or sources of income, and investment preferences of the participant or beneficiary;

 No fiduciary adviser that provides investment advice receives from any party directly or indirectly, any fee or other compensation (including commissions, salary, bonuses, awards, promotions, or other things of value) that varies depending on the basis of a participant’s or beneficiary’s selection of a particular investment option.

The EP members discussed some challenges that may arise in opining on the above items, particularly the underlined phrases. Auditors are concerned that the criteria indicated in the rule may not be easily measurable, and also questioned the form of the report that would be used. EP members will revisit this topic at a future meeting.

2. The Audit Provision under the Custody Rule requires that US GAAS auditing standards be used (refer to Custody Rule FAQ VI.5 http://www.sec.gov/divisions/investment/custody_faq_030510.htm). This presents complications for registered investment advisers (RIA) for foreign funds. Non-US audit firms may be reluctant to perform audits under US GAAS due to limited familiarity with the standards. There are ongoing efforts to clarify US GAAS while converging towards

International Standards on Auditing Standards (ISA). In the May 2012 meeting, the EP discussed this matter with the SEC staff. In the September 2012 EP meeting, an EP member asked the EP about the frequency of cases where an RIA to overseas funds needs to incur an additional cost or burden in order to comply with this requirement for US GAAS. The EP expressed a view that the issue exists but may not be widespread. No further discussion on this topic is anticipated at this time.

3. Rule 17Ad-13 transfer agent report in 11.32 (2011 version) of the Guide is based on a template likely agreed with SEC Trading and Markets (formerly, Markets & Regulation) a number of years ago. (Trading and Markets, not Investment Management, is responsible for regulation of transfer agents.) EP members recently noted that a) in many more instances than had likely existed when the report was last updated, transfer agent data processing systems are

6 maintained by large third-party organizations and provided contractually on a "remote" basis and b) in some instances, registered transfer agents have outsourced substantially all of their actual processing to other agents, retaining only a small piece of the overall function themselves. (The latter most often happens when an advisor wants to maintain the direct investor contact in a telephone center, and for that reason registers as a transfer agent, but outsources all the actual processing to a third party.) While SEC Forms TA-1 and TA-2 allow the transfer agent to advise the SEC of the identities of any other transfer agents to which functions have been outsourced, and Form TA-2 actually provides a check box to indicate "Some" or "All' for the extent of outsourcing, the report template in the Guide does not allow for similar recognition of divided responsibility for various transfer agent functions. Part of this is a function of AICPA standards themselves, which generally do not allow for an auditor to refer to an SSAE 16 report of other auditors in issuing an audit (or attest) opinion. Thus, the 17Ad-13 report as it currently appears in the Guide essentially requires the auditor (along with management in its assertion) to take responsibility for all aspects of the transfer agent function, including

outsourced functions, when the actual operations under management's control may be extremely limited, with the rest of management's responsibility limited to the monitoring of processing by third parties. Particularly where the SEC is already on notice of outsourcing through the TA-2, an EP member expressed concern that the extent of the responsibility being taken by the auditor for transfer agent processing functions in the report is incompatible with the extent of the actual transfer agent activities declared to the SEC by the registrant itself.

An EP member inquired whether other EP members similarly perceive an issue in the current reporting template, and whether the EP may want to pursue an effort with the SEC Trading & Markets to propose an alternative reporting framework, potentially using the "mapping" used for "qualified custodian" internal control reports issued to assist in Rule 206 compliance as a guide, which could make it clear which functions have been outsourced, in order to be more consistent with current transfer agent outsourcing practices. An EP member noted that management is ultimately responsible for maintaining controls over the transfer agent function it outsources and management has to have oversight procedures in place over those controls. The EP may revisit this topic at a future meeting.

4. EP members shared experiences from recent PCAOB inspections.

IV. SEC Staff Update

The following comments and observations were compiled by the AICPA Investment Companies Expert Panel and AICPA staff and are not authoritative positions or interpretations issued by the SEC or its staff. The comments and observations were not transcribed by the SEC or its staff and have not been considered or acted upon by the SEC or its staff. Accordingly, these comments and observations do not constitute a statement of the views of the SEC or its staff.

1. The SEC staff introduced Matt Giordano as a new Assistant Chief Accountant in the SEC’s Division of Investment Management.

2. With respect to the EP’s request to discuss any next steps the SEC may take regarding money market regulations given the recent announcement that a money market fund reform proposal will not be released publically by the SEC, the SEC staff did not provide any additional comments.

3. An EP member inquired about the status of the CFTC’s proposed rule “Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators.” The SEC staff did not comment on this matter, as it is a CFTC rulemaking.

4. The EP members inquired about an update on the SEC yield project. As previously communicated during the May 2012 EP meeting, this is a two-phased effort to (1) determine whether to provide guidance on the SEC yield calculation for Treasury Inflation Protection Securities (TIPS) to address diversity in practice regarding consideration of an inflationary adjustment, and (2) continue a longer-term project to determine whether to develop broad SEC guidance on SEC yield calculations. With respect to Phase 1, the Investment Company Institute (ICI) has formed a working group consisting of funds that hold TIPS with a goal of providing a recommendation.

5. With respect to an IFRS update and its impact on funds, as indicated in previous EP meeting highlights, the 2008 IFRS roadmap indicated that the goal was for the SEC to determine in 2011 whether it should proceed with a rulemaking to require US issuers to adopt IFRS. The SEC staff issued a final report in July 2012

(http://sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-final-report.pdf).

7 Although the SEC has not yet made a decision on IFRS and currently does not have a time table for completion of this project, the SEC staff offered the following observations:

a. Public outreach expressed strong support for the role of the FASB in providing the United States a voice in accounting standard setting.

b. As it related to investment companies, US GAAP and Regulation S-X contain investment company specific guidance whereas IFRS currently does not. If the SEC makes a determination that requires public companies to adopt IFRS and does not exclude investment companies, there is strong public support to retain such industry-specific guidance in GAAP until IFRS addresses investment companies.

6. The EP asked the SEC staff to comment regarding the following issues summary released by the SEC staff on March 29, 2012, and included in the Investment Management Staff Issues of Interest on Funds Using Tender Option Bond (TOB) Financings, published by the staff in the Division of Investment Management; refer to the following link:

(http://www.sec.gov/divisions/investment/issues-of-interest.shtml#tobfinancing). The SEC staff has addressed TOB financings under Section 18 of the Investment Company Act of 1940 (1940 Act) on multiple occasions in reviewing fund registration statements and in the context of other communications with various funds and their counsel. The SEC staff’s position is that a TOB is a financing transaction that involves the issuance of a senior security under Section 18 of the 1940 Act unless the fund segregates unencumbered liquid assets (other than the bonds deposited into the TOB trust) with a value at least equal to the amount of the floaters plus accrued interest. In developing this position, the SEC staff analogized this issue to the SEC staff’s position on reverse repurchase agreements (Reverse REPO) in Investment Company Act Release No. 10666. Release 10666 discussed that the SEC staff’s position was that a Reverse REPO was a financing transaction that may create a senior security under Section 18; nevertheless the SEC staff would not object if a fund segregates unencumbered liquid assets to cover the borrowing. One of the SEC staff’s concerns discussed in Release 10666 was about “pyramiding” where a fund would use the cash proceeds received from a Reverse REPO to enter into another Reverse REPO, and so forth. Therefore, the SEC staff’s position for Reverse REPOs is that the collateral for the Reverse REPO cannot be used as segregated liquid assets. The SEC staff is also concerned about

“pyramiding” of TOB financings, and therefore, the fund has to segregate unencumbered liquid assets (other than the muni bond that was placed into the trust) to avoid creating a senior security.

7. The EP inquired about the SEC staff’s current views on consolidation as a result of the FASB’s decision, during

redeliberations of the Investment Companies project, that an investment company would continue to apply the guidance in 946-810. The SEC staff discussed that regulation S-X, Rule 6-03(c)(1) permits a registered investment company to consolidate another investment company and Rule 3A-02 of Regulation S-X presumes that consolidated financial statements are more meaningful than separate statements and that they are usually necessary for a fair presentation when one entity directly or indirectly has a controlling financial interest in another entity. The SEC staff would generally request a registered investment company or BDC to consolidate a wholly-owned or a substantially wholly-owned subsidiary in its financial statements when that subsidiary is really an extension of the operations of the parent investment company. In response to a question, the SEC staff stated that Section 2(a)(43) of the Investment Company Act of 1940 defines a wholly-owned subsidiary as 95% or more ownership of the outstanding voting securities of a subsidiary. In response to an EP member’s inquiry about the SEC staff’s views regarding the potential new disclosures contemplated by the FASB for each significant interest in an unconsolidated investment company, the SEC staff stated that they have been following the Investment Companies project and are aware of the new potential disclosures that would be required under Topic 946. Some EP members expressed a view that 20-25% may be considered “significant” for registered investment companies, which may result in less information being disclosed in the future. For private funds, some EP members expressed a view that a 5% interest in an unconsolidated investment company may still be significant.

The EP members noted challenges that may exist pertaining to the availability and timing of the receipt of the relevant financial statement information for the purposes of the new disclosures contemplated by the FASB.

8. When a registered investment adviser uses a qualified custodian (QC) to hold member interests in funds, private loan originations (promissory notes, etc.), and participations in private loan originations, for 3(c)(7) or 3(c)(1) private investment pools, the qualified custodian may obtain reporting directly from additional custodians, who also meet the definition of a qualified custodian and hold cash or securities for the pool, incorporate the custodians’ account

statements and send a consolidated statement to the investors of the pool as long as neither of the qualified custodians are affiliates (related person) of an adviser. The SEC staff analogized this to the Custody Rule FAQ Question IX.1 on subcustodians (http://www.sec.gov/divisions/investment/custody_faq_030510.htm).

8 9. The SEC staff has provided no-action relief to investment advisers to 529 plans, specifically stating that “the SEC staff

would not recommend enforcement action to the Commission under Section 206(4) of the Advisers Act and Rule 206(4)-2 thereunder against a registered investment adviser if it treats the 5206(4)-29 Plan for which it is a program manager as a pooled investment vehicle for purposes of the custody rule.” The SEC staff noted a listing of required factors in order to rely on this letter for no-action relief, including:

a. The 529 Plan is a college savings plan;

b. The 529 Plan’s recordkeeper is registered as a transfer agent with the Commission under Section 17A of the 1934 Act;

c. The 529 Plan’s custodian(s) is a “qualified custodian” as such term is defined in Rule 206(4)-2(d)(6) under the Advisers Act;

d. The 529 Plan assets are subject to annual audit as defined in Rule 1-02(d) under Regulation S-X and the audit is conducted in accordance with GAAS;

e. The 529 Plan’s annual audit is conducted by an independent public accountant that: (i) is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the PCAOB in accordance with its rules; and (ii) meets the standards of independence in Rule 2-01(b) and (c) under Regulation S-X;

f. The audited financial statements of the 529 Plan are prepared in accordance with GAAP.

g. The annual financial statements are annually provided to the state agency of instrumentality responsible for oversight of the 529 Plan within 120 days of the end of the 529 Plan’s fiscal year;

h. The annual financial statement are made available to all existing 529 Plan accountholders via the 529 Plan’s website;

and

i. The Program Manager will ensure that the 529 Plan accountholders are provided written notification of the availability of the financial statements no later than the delivery of the accountholders’ next regularly scheduled quarterly account statement. Such notice may either be included with or on such statement or sent separately. The notice shall advise the accountholder of a website where such financial statements may be accessed and provide the accountholder information regarding how to contact the 529 Plan to obtain a hardcopy of such financial statements in lieu of accessing them online. A hardcopy of the financial statements shall be provided by mail within 3 business days of an accountholder requesting such a copy.

For full text of the letter, visit http://sec.gov/divisions/investment/noaction/2012/ici090512.htm.

10. The SEC staff shared the following financial statement review comments:

a. The SEC staff discussed a recent registration statement filed by a business development company (BDC). The BDC held a material investment in an unregistered co-investment funding vehicle which made loans to private companies. The BDC did not consolidate the co-investment vehicle because it did not have control. The SEC staff required the BDC to update its registration statement to include certain summarized financial statement

information (balances from balance sheet and income statement) as well as a full schedule of investments despite the fact that this co-investment vehicle was not using investment company accounting. This is because the detailed loan portfolio is material information to the BDC’s investors given the size of the BDC’s investment in the co-investment vehicle. Going forward, the SEC staff requested that the BDC’s quarterly and annual filings include a detailed schedule of investments and summarized financial information of the co-investment vehicle. In cases where a BDC or fund has such a significant unconsolidated investment in a nonregistered entity, registrants should

consider the guidance in Regulation S-X Rule 3-09 and Rule 4-08(g) in connection with determining whether to attach financial statements of the subsidiary or include summarized financial statement information, including a schedule of investments.

b. The SEC staff noted diversity in practice regarding the fee table presentation in Form N-1A when a fund consolidates a wholly owned subsidiary. Some registrants are including the subsidiary’s expenses in “Acquired Fund Fees and

9 Expenses” (AFFE), while other registrants are retaining the character of the subsidiary’s expenses. The SEC staff reminded registrants of Item 3, Instruction 3 in such cases, and noted that the character of the expenses at the subsidiary level should be retained when populating the fee table in Form N-1A, as the subsidiary is consolidated.

c. The SEC staff discussed credit risk-related contingent feature disclosures. Examiners noted that certain funds did not include all required disclosures identified in ASC 815-10-50-4H. There are currently six disclosure requirements in this paragraph, two qualitative and four that are quantitative in nature. The SEC staff noted divergence in disclosure practices, and reminded registrants to carefully evaluate counterparty agreements in order to identify all features that need to be disclosed. Some registrants had qualitative disclosures about triggers (e.g. a percentage decrease in a Fund’s net assets or NAV) but lacked the required quantitative disclosures. These disclosures should be included in the notes to financial statements, as they are required by GAAP in ASC 815.

d. The SEC staff and EP members discussed credit valuation adjustments (CVAs) for derivative contracts, and the extent to which investment companies are including CVAs for OTC derivative contracts, particularly when the instruments are not fully collateralized. The SEC staff referred to the 2008 “Dear CFO Letter” issued by the Division of

Corporation Finance, which suggested including disclosures in the MD&A about how credit risk affected the valuation of its derivative assets and liabilities. The SEC staff reminded registrants that in accordance with ASC 820, CVAs are required to be included in the fair value measurements of derivative assets and liabilities, and may need to be considered when registrants use quotes from brokers or pricing services in developing fair value measurements.

DISCLAIMER: This publication has not been approved, disapproved or otherwise acted upon by any senior technical committees of, and does not represent an official position of, the American Institute of Certified Public Accountants. It is distributed with the understanding that the contributing authors and editors, and the publisher, are not rendering legal, accounting, or other professional services in this publication. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

Copyright © 2012 by American Institute of Certified Public Accountants, Inc. New York, NY 10036-8775. All rights reserved. For information about the procedure for requesting permission to make copies of any part of this work, please email [email protected] with your request. Otherwise, requests should be written and mailed to the Permissions Department, AICPA, 220 Leigh Farm Road, Durham, NC 27707-8110.