Custody Rule:

a. The SEC staff discussed a question on the frequency of the annual surprise examination performed pursuant to the Custody Rule. SEC Release No. IA-2969 “Commission Guidance Regarding Independent Public Accountant Engagements Performed Pursuant to Rule 206(4)-2 Under the Investment Advisers Act of 1940” indicates that “Rule 206(4)-2(a) generally requires that client funds and securities of which an investment adviser has custody under the rule be verified by actual examination at least once during each calendar year by an independent public accountant.” Based on SEC FAQ Question I.3, certain advisers engaged accountants to perform the first surprise examination as of early 2011 (e.g., January 31, 2011). The EP and SEC staff discussed a scenario whereby the next surprise examination will be performed as of November 30, 2012 (in the next calendar year), and there would be a 22-month time period between surprise examinations. The SEC staff indicated that as long as the November 30, 2012 examination is conducted on a “surprise” basis, the date would be acceptable as Rule 206(4)-2(a)(4) requires the surprise examination to be performed at least once per calendar year. As per the Guidance in IA-2969, the accountant is also required to opine on the adviser’s

compliance with Rule 204-2(b) for the period since the prior surprise examination, which is this example, would cover the 22-month period.

b. During several meetings and calls in 2010 and in April 2011, the SEC staff and EP members discussed the application of Question XII.1 of the SEC’s FAQ’s and the application of the custody rules to a participant-directed defined contribution plan where one of the investment options is a pooled investment vehicle which has the same adviser as the related person trustee of the plan. According to the FAQ, the adviser must treat the assets of the plan as client assets of which it has custody. The EP member inquired if an adviser can satisfy the custody rule for the plan using the audit provision (or is it not considered a pooled investment vehicle and could not use the audit provision in accordance with Question X.1 of the FAQs). The staff indicated that in these situations all the plan assets are subjected to the custody rule as both the plan and the fund are clients of the investment adviser. The investment adviser cannot avail itself of the audit provision for the defined contribution plan. The SEC additionally reminded the EP members that the defined contribution plan’s interest in the pooled investment vehicle needs to be held by a qualified custodian (which, for a 1940 Act mutual fund, may be the fund's transfer agent). At the April 2011 conference call, the staff informed the expert panel members that there were no updates on this matter. An EP member indicated that a letter requesting no-action relief has been submitted to the SEC on this matter. During September 2011 EP meeting, the SEC staff indicated that there is no update on this matter at this time.

2. Other

a. The February 2011 EP conference call highlights indicated that for funds with expense recapture plans, “due to improved market conditions, funds may have to pay back expenses that have been waived previously. In these situations where expenses are being paid back, within its registration statement -, the funds should use a separate line item in the fee table, similar to the presentation treatment for a contractual fee waiver”. Instruction 3(c)(iii) to Item 3 of Form N-1A (page 13) indicates that within “Other Expenses”, the Fund may subdivide this

caption into no more than three sub-captions that identify the largest expense or expenses comprising “Other Expenses.” Frequently, the amount paid is not quantitatively significant, and is not among the three largest components of “Other Expenses”. However, due to the

qualitative importance of this item, the SEC staff indicated that in such cases, the fund should separately present these amounts paid. The staff was not prescriptive in where the disclosure should be in the table and would not object if these amounts were presented similar to the presentation of a contractual fee waiver or if they are included in “Other Expenses”, even when they are quantitatively not among the three largest components of “Other Expenses”. The SEC staff indicated that there are no current plans to update the Form N-1A instructions for this matter, and encouraged registrants to discuss presentation considerations with their examiner.

b. The SEC issued Concept Release No. IC-29776 “Use of Derivatives by Investment Companies under the Investment Company Act of 1940” requesting comments on a number of issues, including the potential implications for fund leverage, diversification, exposure to certain securities-related issuers, portfolio concentration and valuation, and invites public comment on any other matters that they believe are relevant to the use of derivatives by funds. Upon receiving comments, the Commission will consider whether regulatory initiatives or guidance related to derivatives are needed to improve the current regulatory regime for funds.

c. Earlier in the meeting, EP discussed the content of BDCs’ audit opinions and noted

inconsistency regarding inclusion of a statement regarding confirmation of securities with the custodian. The EP noted that the staff was making comments that certain audit opinions on BDCs’ financial statements did not include that statement. It was also noted that certain BDC auditors were confirming securities owned by the BDC but did not include the statement to that effect in the audit opinion. The staff indicated they are discussing with IM’s Chief Counsel’s Office whether BDC auditors are required to include in their opinions a statement regarding confirmation of securities owned by the BDC.

d. Financial statement review comments:

i. Consolidation – the staff brought to the EP’s attention the following matter on which a registrant and its auditor consulted the staff: An open-end registered investment company (Fund) invests in a wholly-owned, non-SEC registered Cayman Islands tax blocker (Cayman Blocker). The Cayman Blocker invests in a wholly-owned non-SEC registered commodity pool (CP). The Fund’s ultimate exposure to the CP could represent up to 25% of the Fund’s total assets. The arrangement represents a 3-tiered structure. The staff noted that the Fund consolidated the Cayman Blocker in its semi-annual financial statements, but the Cayman Blocker did not consolidate the CP (and therefore the Fund did not consolidate the CP) even though the Cayman Blocker owns 100% of the CP and economically controls it. The Fund’s semi-annual financial statements reflected the investment in the CP within the investments line item on the balance sheet and reflected the name of the CP on the SOI. The Fund’s semi-annual financial statements did not provide any transparency into the holdings or expenses of the wholly-owned CP. In addition, the Fund’s expense ratio did not reflect the expenses of the CP. The registrant initially concluded the Cayman Blocker should not consolidate the CP based on Rule 6-03(c)(1) of Regulation S-X that states that registered investment companies may only consolidate investment companies. The CP is neither an investment company, as defined in the 1940 Act, nor an entity that would be an investment company under the 1940 Act but for the exceptions in Sections 3(c)(1) or 3(c)(7).

The staff informed the registrant that under GAAP, the consolidation analysis needs to be evaluated using a “bottom up” approach. First the registrant should determine whether the Cayman Blocker should consolidate the CP. Since both the Cayman Blocker and the CP are non-SEC registered funds and are both investment companies under GAAP, the registrant determined the Cayman Blocker should consolidate the CP because it has a controlling financial interest in the CP. Next, the registrant should

determine whether the Fund should consolidate the Cayman Blocker. Since the registrant had previously determined the Fund should consolidate the Cayman Blocker, the registrant determined it was appropriate to consolidate the whole 3-tiered structure. Therefore, upon consolidation in its audited annual report, the Fund included all of the CP’s investments in its SOI and included the CP’s expenses in its statement of operations and expense ratio.

The staff indicated that IM’s Chief Counsel’s Office is determining whether the Fund’s compliance with the 1940 Act and rules thereunder would be based on the

consolidated structure (i.e., whether the Fund would look through to the Cayman Blocker’s and CP’s assets, liabilities and p&l to determine compliance).

The staff also informed the EP that another registrant created a structure similar to the one described above in order to obtain exposure to commodities. In this fact pattern, an open-end registered fund invests in a wholly-owned non-SEC registered Cayman tax blocker and the Cayman tax blocker invests in 5 wholly-owned non-SEC registered commodity pools. The Fund’s exposure to the commodity pools in the aggregate could represent up to 25% of the Fund’s total assets. Subsequent to the staff’s review of the registrant’s financial statements, this registrant concluded it was appropriate for all entities to be consolidated. The analysis performed by the registrant was similar to the one mentioned above.

The staff also reminded the EP that 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.

ii. The staff provided an update on a topic discussed during previous EP meetings - accrual of incentive fees. To be consistent with AICPA TIS 6910.29 and the Guide and to ensure proper NAV calculation, the staff previously mentioned that BDCs should be accruing incentive fees on an unrealized net gain position even if the adviser is not yet entitled to payment of the incentive fee since the gains have not been realized. The SEC staff noted that they have observed that certain Registered Funds of Hedge Funds with March 31 fiscal year-ends were not properly accruing incentive fees/allocations in their financial statements. Such Registered Funds of Hedge Funds have provisions in their offering documents that provide that incentive fees/allocations crystallize and are payable to the adviser/GP at December 31. The staff has observed that these Registered Funds of Hedge Funds accrue the incentive fees/allocations on the statement of operations/statement of changes through December 31 and disclose the amount of incentive fees/allocations payable from January 1 through March 31 in the footnotes. The staff believes that for a fund with a March 31 fiscal year-end, incentive fees/allocations should be accrued on the statement of operations/statement of changes for the period from April 1 through March 31, even if the incentive fees/allocations are payable to the adviser/GP on December 31. Further, the staff reminded the EP that when making fair value determinations of investee hedge funds, Registered Funds of Hedge Funds should consider whether the investee hedge funds properly accrue incentive fees/allocations.

iii. Variable rate demand (VRD) notes – During the financial statement review process, the SEC staff observed that there were certain funds holding VRD notes with liquidity enhancements (in addition to credit enhancements). The staff learned that only a few large banks provide these liquidity enhancements and that not all mutual funds were disclosing the liquidity enhancements, the liquidity enhancement providers, and the possible credit concentration provided in these arrangements. The staff reiterated that when funds have investments in securities with liquidity enhancements, funds

should consider the guidance in ASC 946-210 regarding identification of 3rd parties providing credit enhancements. The disclosure would include the name of the liquidity provider in the security’s description in the Schedule of Investments and discussion of the liquidity enhancement arrangements within the notes to the financial statements.

e. The EP members inquired about the staff’s reaction to the decision reached by the FASB in connection with the Investment Companies Consolidation Project to issue an Exposure Draft that as expected to be proposed, would require investment companies to consolidate other investment companies that are controlled. The staff indicated they have been monitoring the project.

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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.

Financial Reporting Center – Industry Insights

Investment Companies Expert Panel

Highlights of the October 13, 2011, Conference Call

The Investment Companies Expert Panel serves the needs of AICPA members on financial and business reporting and audit and attest matters. The expert panel protects the public interest by bringing together knowledgeable parties in the investment companies industry to deliberate and come to agreement on key investment company issues.

I. Administrative items/AICPA matters:

1. The AICPA staff informed the Expert Panel (EP) about status of the September EP meeting notes.

2. The EP chair discussed EP composition in the upcoming volunteer year.

3. The AICPA Publications staff informed the EP about current status of the Investment Companies Audit Risk Alert. It is anticipated that the Alert will be available in December 2011.

4. The next Expert Panel meeting is scheduled for Wednesday, November 16, 2011, at the AICPA NYC office.

II. Accounting/Reporting Issues

1. The EP members are developing best practice guidance (non-authoritative) on what would be considered a security and what would be considered a derivative under GAAP for investment companies, and anticipate sharing the draft guidance with the EP in advance of the November 2011 EP meeting.

2. EP members represented on the ICI subcommittee continue working on a white paper on accounting for dollar rolls. The white paper is expected to be finalized by the end of October 2011 and will include feedback collected from the EP’s previous discussions on dollar rolls.

3. The AICPA staff updated the panel members on the timing of upcoming proposed Accounting Standards Updates on Financial Services - Investment Companies, Real Estate - Investments Property Entities, and Consolidation - Policy and Procedures projects. Former FASB staff will be joining the November EP meeting to discuss these projects.

4. In connection with a question raised by one member, the EP expressed a view that investments in registered investment company (RIC) would generally be classified as a Level 1 security under the ASC 820 fair value hierarchy. An EP member referred to ASC 320, which states that the fair value of an investment in a mutual fund is readily determinable if the fair value per share (unit) is

determined and published and is the basis for current transactions. The EP noted that the definition

of Level 1 in ASC 820 does not include "readily determinable", however it appears consistent with other types of Level 1 investments.

III. Audit and Attestation Issues

1. The panel members discussed the recently issued PCAOB Staff Audit Practice Alert No. 8 “Audit Risks in Certain Emerging Markets”, which focuses on risks of material misstatement due to fraud that auditors might encounter in audits of companies with operations in emerging markets. The EP discussed the potential impact on valuation of investments in emerging markets, particularly in China. In some cases, the trading of securities has been halted, and there have been issues with missing regulatory filings, and resignation of auditors or board members.

For entities that are primarily invested in securities in Asia or China, the EP discussed whether there should be risk disclosures in the notes to financial statements discussing current business

environment and risks. The EP members shared that some are considering expanding emerging markets risk disclosure and corporate governance disclosures, and the EP plans to revisit this topic during the November EP meeting.

2. Regarding the SEC Custody Rule, when performing surprise examinations, the EP discussed whether accounting firms are performing procedures to determine if the qualified custodian sends account statements directly to clients at least quarterly, in accordance with Rule 206(4)-2(a)(3). If auditors become aware that the adviser is not sending statements on at least a quarterly basis, that may represent a material discrepancy. The EP members discussed that if the auditor becomes aware of material noncompliance, the auditor may need to report such instance to the SEC, but there is no specific objective to inquire whether a qualified custodian sends quarterly account statements to its clients. The EP members discussed that accounting firms are inquiring with the RIAs whether they have a reasonable belief that such statements are being sent on at least a quarterly basis, but noted that looking for quarterly statements sent to the adviser’s clients is generally not part of the design of specific procedures relating to a surprise examination.

3. The PCAOB has recently released a proposed rule that would require disclosure of the name of the engagement partner in the auditors’ report and the annual form filed with PCAOB, as well as the name of any other person or accounting firm that took part in the audit. The proposed

requirements would assist the user of the financial statements in identifying whether the other person or accounting firm are registered with the PCAOB and whether they have been subject to disciplinary actions. Comments on the proposed rule are due by January 9, 2012.

IV. SEC Update

These highlights are not authoritative positions or interpretations issued by the SEC or its staff. The highlights were not transcribed by the SEC and have not been considered or acted upon by the SEC or its staff. Accordingly, these highlights do not constitute a statement of the views of the Commission or the staff of the Commission.

1. Megan Monroe joined the SEC Investment Management Division staff as a new Assistant Chief Accountant.

2. Custody Rule:

a. During several meetings and calls in 2010 and in April 2011, the SEC staff and EP members discussed the application of Question XII.1 of the SEC’s FAQ’s and the application of the custody rules to a participant-directed defined contribution plan where one of the

investment options is a pooled investment vehicle which has the same adviser as the related person trustee of the plan. According to the FAQ, the adviser must treat the assets of the plan as client assets of which it has custody. The EP member inquired if an adviser can satisfy the custody rule for the plan using the audit provision (or is it not considered a pooled investment vehicle and could not use the audit provision in accordance with Question X.1 of

the FAQs). The staff indicated that in these situations all the plan assets are subjected to the custody rule as both the plan and the fund is a client of the investment adviser. The

the FAQs). The staff indicated that in these situations all the plan assets are subjected to the custody rule as both the plan and the fund is a client of the investment adviser. The