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Accounting and Financial Reporting Update (2016)
The ninth edition of our annual update highlights selected accounting and reporting developments that may be of interest to investment management entities. Among other topics, the publication discusses (1) the issuance of refinements to the new guidance on recognition of revenue from contracts with customers, (2) the issuance of new guidance on classification and measurement of financial instruments, and (3) the SEC’s continued focus on rulemaking, particularly in connection with its efforts related to investment company report modernization, liquidity risk management, and swing pricing.
The year 2016 has seen continued economic improvement, as evidenced by increasing consumer confidence, strong market performance, and the Federal Reserve’s elevation of the federal funds rate. However, Brexit has created near-term uncertainty and volatility in Europe, and the effects on the market of a new U.S. president and administration are unknown.
The sense that the investment management industry is poised for disruption remains strong, as does the belief that there are tremendous opportunities, and associated risks, within the industry. Advanced technology may rapidly bring down the cost of active portfolio management for firms that embrace it, and blockchain is a potentially game-changing technology and a possible threat to established players. Shifting wealth and changing demographics along with the rapidly evolving economic environment are likely to affect the industry for several more years.
The industry also faces increased regulatory compliance and competition. As a result, investment managers should expect greater compliance costs as well as pressure to produce higher returns for lower management fees. To retain existing investors and attract new prospects, investment managers will need to differentiate themselves.
Investment Company Report Modernization
On October 13, 2016, the SEC finalized its Investment Company Report Modernization rules, making sweeping changes to registered investment company reporting. The new and amended rules are intended to keep up with changes in the industry and technology as well as to provide more timely transparency to the SEC and investors. The new rules will create forms such as N-PORT and N-CEN, replace existing forms such as N-Q and N-SAR, and considerably reduce the filing requirements for other forms. In addition to the new forms, the SEC has adopted amendments to Regulation S-X to, among other things, enhance and standardize derivatives disclosures in financial statements to allow for comparability among funds. These changes, will significantly affect the industry and should be reviewed by investment companies, investment advisers, and investors.
Investment Company Liquidity Risk Management and Swing Pricing Rules
The SEC has begun an initiative to promote effective liquidity risk management throughout the open-end-fund industry by (1) requiring funds to adopt a liquidity risk management system and (2) permitting (but not requiring) registered funds to use “swing pricing.”
The liquidity risk management rules are intended to reduce the risk that mutual funds and ETFs will not be able to meet shareholder redemptions and mitigate potential ownership dilution of the residual shareholders. Under the new rules, mutual funds and ETFs will be required to establish programs under which the assessment, management, and periodic review of a fund’s liquidity risk would be performed and the oversight of boards would be enhanced.
In addition, the SEC intends to further enhance the monitoring and disclosure of both fund liquidity and redemption practices by permitting swing pricing. Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity so that those costs can be passed on to the purchasing and redeeming shareholders. It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks.