Mutual fund Valuation and Accounting

Executive Summary

Mutual fund is a trust that pools the savings, which are then invested in capital market instruments such as shares, debentures and other securities. It works in a different manner as compared to other savings organizations such as banks, national savings, post office, non-banking financial companies etc. as most, if not all capital market instruments, have an element of risk, it is very essential that the investors have a clear understanding of how mutual fund operates and what are the advantages as well as limitations, how the net asset value (NAV) are calculated and what is the impact of dividend on NAV etc. this understanding has to be created among the investors by the distributors engaged in the marketing of mutual fund products. The distributors should also be knowledgeable enough to answer fundamental and basic questions raised by the investors. The distributors need to understand accounting for the fund’s transactions with the investors and how the fund accounts for its assets and liabilities which is essential for them to perform basic role in explaining the mutual fund performance to the investors. For example, unless the distributor knows how the NAV is computed, he cannot use even simple measures such as NAV change to assess the fund performance. He should also understand the impact of dividends paid out by the fund or entry/exit loads paid by the investor on the calculation of the NAV and therefore the fund performance.

INTRODUCTION:

Meaning:

The mutual fund industry in India started in1963 with the formation of Unit Trust of India, at the initiative of the Reserve Bank and the Government of India. The objective then was to attract the small investors and introduce them to market investments.

In a mutual fund, many investors contribute to form a common pool of money. This pool of money is invested in accordance with a stated objective. The ownership of the fund is thus joint or mutual; the fund belongs to all investors. A single investor’s ownership of the fund is in the same proportion as the amount of the contribution made by him bears to the total amount of fund.

A mutual fund uses the money collected from investors to buy those assets which are specifically permitted by its stated objective. Thus, a growth fund would by mainly equity assets- ordinary shares, preference shares, warrants, etc. An income fund would mainly buy debt instruments such as debentures and bonds. The fund’s assets are owned by the investors in the same proportion as their contribution bears to total contributions of all investors put together.

When an investor subscribes to mutual fund, he becomes part owner of fund’s assets. In USA, mutual fund is considered as an investment company and an investor “buys into the fund”, meaning he buys the shares of the fund. In India, a mutual fund is constituted as a Trust and the investors subscribes to the “units” of a scheme launched by the fund, which is where the term unit Trust comes from. The term “unit-holder” is used to denote the mutual fund investor which includes in both the open-end and close-end schemes.

In an open-end scheme, investors can buy and sell units from the fund continuously. The stock exchange is not in picture. To ensure that there is fairness, sale and purchase has to take place at fair value of the unit. Since the units held by an investor evidence the ownership of the fund’s assets, the value of the total assets of the fund when divided by the total number of units issued by the mutual fund gives us the value of one unit. This is generally called as Net Asset Value (NAV) of one unit or one share. The total value of an investor’s part ownership is thus determined by multiplying the NAV with the number of units held. As the fund’s investments are revalued at their market prices, the net value of investments will change depending upon the way prices of the investments move in the market. Therefore, the NAV of the fund also fluctuates.