challenges for mutual fund auditors—a view from the front line

Challenges for Mutual Fund Auditors—A View from the Front LinePresented to the XXI Annual Meeting of the International Investment Funds Association

by Wm. David SeymourGlobal Head, Investment Management & Funds2 November, 2007

Financial Services: Investment Management & Funds

2© 2007 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in the U.S.A. 12009LIO - TMPLT

Agenda

Setting the Stage

– Role of the Mutual Fund Auditor

– Supporting the Board’s Fiduciary Responsibilities

Differentiating Auditor Concerns from Business Concerns

Key issues facing Auditors and the Mutual Fund Industry

– Valuation

Sub-prime issue and impact

FAS 157

Fair Valuation-Further Thoughts

– IFRS and US GAAP Considerations

– Selecting and Appointing an Auditor

Question and Answer

Wrap-up

Setting the Stage


Role of the Mutual Fund Auditor

Capital Markets integrity

Statutory requirements

Risk assessment and control advice


Supporting the Board’s Fiduciary Responsibilities

Auditor works for the Board (Responsible Entity charged with Governance)

Local governance models dictate interactions

Professional responsibilities and regulatory requirements

Differentiating Auditor Concerns from Business Concerns


Interrelationship on Audit and Business Concerns

Business issues and concerns drive auditor risk assessment

Business concerns operate 365 days per year

Auditor concerns operate at financial reporting dates and consider/test activity throughout the year

Key Issues Facing Auditors and the Mutual Fund Industry



Valuation

– Sub-prime issue and impact

– FAS 157

– Fair Valuation-Further Thoughts

IFRS and US GAAP Considerations

Selecting and Appointing an Auditor

Sub-Prime


Sub-Prime Surprise

Merrill Lynch takes $8.4 billion write down for CDO’s and sub-prime

State Street sued over fund loses due to investments in sub-prime

Citigroup, Deutsche Bank, Morgan Stanley, Goldman Sachs and Lehman combine for over $20 billion in losses

Existing-home sales fell 8% in September, with single-family sales hitting their lowest sales pace in nearly 10 years

Median home price dropped 4.2% from a year earlier

Components of the Crisis

– Sub-prime

– Leverage Finance

– SIVs and Asset backed commercial paper


What Happened?

Everyone forgot that Sub-prime credits are weak by their nature and are not diversified

Delinquency and default rates accelerated rapidly

Falling housing prices create underwater loans

Poor lending standards

Risk of fraud in lending process

Extremely complicated structures—multitude of derivatives (hedges)

Loss of faith in rating agencies


Impact

Dislocation in the Repo and Commercial Paper markets

Valuation issues abound

Borrowing costs increased in the high yield sectors

Private Equity activity dramatically impacted

Numerous mortgage banking entities closed

Major players exit sub-prime business

Market correction may not be done yet


Lessons Learned

Need for greater diversification

Ensuring adequate liquidity is of utmost concern

Determine which entity funds which component of a deal

Superfund rescue attempt

FAS 157



Definition of Fair Value

– Per FAS 157, “Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.

– Fair value measurement’s objective is to determine the value or price that would be received to sell an asset or paid to transfer a liability in that asset’s or liability’s principal market.

– The principle market is that market with the greatest level of activity or volume for that asset or liability.

Valuation Techniques

– Market

– Income

– Cost



Types of Inputs

Level 1- Observable:

– Represents quoted prices in active markets.

– Exchange traded securities

– Broker quotes in an active market

Level 2 - Observable:

– Represents quoted prices in less active markets; or markets where the assets and liabilities are not identical.

– Observable inputs other than quoted prices (in active markets) including interest rates and yield curves (i.e., matrix pricing and fair value models).



Level 3 – Unobservable. When a valuation technique utilizes inputs that are different, the fair value hierarchy is determined based on the lowest level of significant input.:

– Unobservable inputs for the asset or liability developed on the best information available.

– Fair valued securities in which no indicators or comparables are available and the underlying entity’s financial information is used to calculate valuation.

– Generally, internally developed pricing.



Disclosures

– All fair value measurements.

– The level in which the assets are classified.

– For those in level 3, a reconciliation shall be provided including:

Total unrealized and realized gains and losses for the period (including change in unrealized gains and losses in assets/liabilities) still held at the reporting date

– Purchases and sales

– Transfers in and out

– In annual periods, a description of valuation techniques utilized and disclosure of any changes.



Additional Points

– Treatment of acquisition costs and blockage factors.

– Most entities will evaluate market inputs on groups of securities.

– Certain vendors are already providing written documentation surrounding their policies and procedures to help their clients evaluate their measurement hierarchy.



SEC views on fair valuation

– 2004 Accounting and Auditing Enforcement Release

– Important to distinguish “forced sales” from market imbalances (however uncomfortable)

– Registrant assumed market imbalances did not exist to determine fair value

– SEC objected to ignoring external pricing sources and taking a “long view” of the market

– Persuasive evidence is required to establish an observable transaction is a forced or distressed transaction



Accounting rules must acknowledge fiduciary vehicles, such as funds

– US GAAP does

– IFRS does not presently

IFRS creates unintended consequences

– Bid pricing

– Expensing of transaction costs

– Results in different economic outcome in annual report

Selecting and Appointing a Mutual Fund Auditor


Selecting and Appointing a Mutual Fund Auditor-Governance Considerations

Role of non-management directors

– Local Statute (for example, US SEC requirements)

– Need to negotiate with any independent directors/boards

Consideration of various auditor independence rules

Consideration of consolidation of funds into consolidated financial statements

Ability of Management to make auditor appointments for funds

Safeguarding Fund shareholders’ interests

“How do you feel” about auditor relationships with affiliates?


Funds Governance Assessment “Decision Tree”

Is the fund subjectto consolidationinto FS Group?

Is the fund registeredunder US SEC Regulations?

Does the fund havenon-management

directors(independent)?

Are there relevant localrules governing

auditor appointment?

Are such funds requiredto be consolidated

into FS Group?

Independent fundboard appoints

auditor by statute

Consideration must be given toresponsibilities of non-management

directors under local/regionalrules/regulation

Consider impactof such rules

Management shouldbe able to control

auditor appointments

Yes

Yes

Yes

Yes

No

No

No

No

No


Selecting and Appointing a Mutual Fund Auditor-Risk Management Improvement Opportunity

Multiple service providers may assess risk inconsistently

Disparate relationship management

Opportunity to centralize risk assessment and improve feedback to senior management

Better able to manage threats to auditor independence


Selecting and Appointing a Mutual Fund Auditor-Cost Management

Centralised relationship management should result in:

– Economies of scale

– Standardisation of processes

– Deeper overall relationship with senior management

Result should be improved risk assessment at an overall reduced cost


Selecting and Appointing a Mutual Fund Auditor-Unique Statutory/Tax Requirements

Service provider must be able to demonstrate expertise in financial reporting and taxation in each country

Service provider must be able to serve varying types of fund products (mutual funds, hedge funds, private equity, real estate, fund of funds, etc.)


Selecting and Appointing a Mutual Fund Auditor-Global Regional Coordination

Large financial services organisations generally have a central point of contact (as best fits the organisation):

– Globally

– Regionally

Such coordination is viewed as a best practice to ensure maximum risk management

Questions?

Wrap-up

challenges for mutual fund auditors—a view from the front line

Economy & Finance

kpmg llp

kpmg international

limited liability partnership

swiss cooperative

lio tmpltinterrelationship

lio tmpltrole

lio tmpltsupporting

lio tmpltsub