double-checks everything. “Does this NAV look reasonable in light of every- thing we did today? Is the overall change in NAV per share consistent with the impacts we calculated for the individual components?” Once he is sure that everything is correct, he designates the fund as “balanced,” so the NAV per share can go on the transmission to NASDAQ at 5:50 PM.
At 5:25 someone fi nds a bad security price, and the NAVs for some of the funds have to be recalculated. (“This is a ripple effect from getting the equity trades so late,” Russell comments. “We didn’t have as much time as we usu- ally do to check prices.”) There is a fl urry of activity as accountants work to complete and verify these funds before the 5:50 PM deadline for submitting NAVs to NASDAQ. At 5:48 PM the last fund is balanced, and all the funds make the transmission.
By 5:50, the tension and activity levels in the room have dropped notice- ably. Russell and the other fund accountants get ten-page printouts summa- rizing the books for each of their funds. They do one fi nal round of double- checking the fi gures, make sure every adjustment or reconciliation they made is clearly documented, and complete their fi ling, so that there are no loose ends left for tomorrow. Finally, as 7:00 PM approaches, all the accountants have fi nished their days, and the fl oor is deserted. State Street Bank’s fund accountants have once more performed their daily small miracle.
Fund Accounting, Audit, Legal, and Other Support Functions 147 tions the fund has assigned to these securities, by independently obtaining prices (as required by SEC rule) for all securities as of the audit date, and comparing these to the prices used by the fund’s accountants for that date.
The auditor further reviews and tests the processes by which fund man- agement monitors compliance with regulatory and prospectus restrictions on portfolio holdings.
2. Investment income and realized gains. The auditor tests whether all income earned by the fund’s holdings has been recorded in the fund’s fi nancial records. It examines portfolio sales transactions, and tests the calculation and classifi cation of capital gains. This examination of gains and losses typically includes a review for wash sales—securities disposi- tions on which capital loss is disallowed for tax purposes due to proximity to acquisitions of identical securities.
3. Accruals and expenses. The auditor examines expense records to deter- mine whether they are in accordance with the provisions of the invest- ment advisory agreement, prospectus, and other relevant contracts. The auditor recalculates the management fee and any other fees that are based on the assets of the fund, and compares them against the fees actually charged. Other expenses are reviewed for proper authorization.
4. Taxes. The auditor reviews the fund’s compliance with requirements of the tax laws, especially those that allow it pass-through status. Should a fund fail to meet the requirements for pass-through status, the conse- quences (i.e., having to pay taxes at the fund level) would severely harm the fund and its advisor—through mass shareholder redemptions, bad press, and even litigation.
5. Shareholders’ equity. The auditor reviews the internal controls of the fund’s transfer agent (usually by considering a report on the results of a control examination issued by independent auditors for the transfer agent), and tests the computations of the net asset value per share that are used in the daily purchase and sale transactions for fund shares.
Finally, the auditor reviews the fi nancial reports that the fund issues.
Mutual fund fi nancial statements typically include a year-end balance sheet, a statement of operations for the most recent year, and statements of changes in net assets for the two most recent years. In some cases, a statement of cash fl ows may also be required. Additionally, the statements include a fi ve- year summary of fi nancial highlights, and a schedule of every security holding as of the statement date, including name, quantity, value, type and category (industry or similar grouping). In a recent amendment to shareholder report- ing requirements, the SEC allowed funds to present a condensed portfolio in
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the reports mailed to shareholders, consisting only of the 50 largest holdings (by issuer) in the portfolio and any other holding of an issuer exceeding one percent of net assets, so long as the full portfolio was included in a report fi led with the SEC and made available to any shareholder on request. While this new fl exibility has only recently come into effect, at present it appears that only a few funds with very large portfolios are taking advantage of it, mainly to save on the costs of printing and mailing to shareholders something that at times began to resemble a small town’s telephone directory.
The auditor’s report for the Vanguard Wellington Fund, shown in Figure 7.2, is typical of those found in mutual fund annual reports. A mutual fund audit rarely results in a qualifi ed opinion—that is, one in which the auditor notes any divergence from GAAP. The SEC would not permit fi nancial state- ments with an opinion qualifi ed for such a divergence (or for a limitation on the scope of the audit) to be included in a registration statement, thus effec-
Figure 7.2 Auditor’s report for the Vanguard Wellington Fund.
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Fund Accounting, Audit, Legal, and Other Support Functions 149 tively suspending further sales of the fund’s shares. Therefore, as a practical matter, fund management must correct any shortcoming that the fund’s audi- tor believes represents a material departure from GAAP. Rarely, however, do fund management and the auditors fi nd themselves in an adversarial position over an accounting issue at year end. In the vast majority of cases, the audi- tors work with fund management throughout the year to identify troublesome practices and suggest corrections before they become audit issues.
The cost of auditing for an individual fund varies widely, from under
$10,000 to over $50,000, depending on a number of factors. The least expen- sive funds to audit hold a relatively small number of easily priced securities, require only basic attestation services, and have their records kept by a com- plex whose internal processes the audit fi rm knows have been examined and found to be well controlled. More expensive audits are required for funds that hold large numbers of securities or especially complex or hard-to-price secu- rities (for example, certain derivatives, private placements, or emerging-mar- ket securities), require extra services, or require that the auditor spend more time and effort examining internal procedures of the fund’s record keeper.
Large fund complexes that have many individual funds audited by one audit fi rm are often able to obtain lower audit fees, as the auditors are able to rely on common control systems and perform large numbers of audits simultane- ously, allowing them to spread certain fi xed audit costs over a larger number of funds.