Mutual Funds: Financial Reporting and Internal Controls Day 1

1. Mutual Funds:Financial Reportingand Internal ControlsDay 1 Presented by Altaf Noor Ali Chartered Accountant

2. Mutual Funds:Financial Reportingand Internal Controls Keynote address by Mr. Nasim Beg Chairman, Mutual Funds Association of Pakistan [CEO, Arif Habib Investment Management Ltd and a Chartered Accountant]

3. Mutual Funds as investments MF: Financial Reporting Framework MF: Model Financial Statements Review MF and benchmarks MF: Internal financial reporting Session Objectives: Outline the present scheme of external financial reporting. Discuss ideas about improving it. Outline internal financial and non-financial reporting. Day 1: 9.30 am – 5.00 pmMutual Funds: Financial Reporting

4. Let us melt the ice with an introduction. Tell us: Your name and education Your position, department & organisation Duration in present position Your most important function Feel free to express yourself in a language of your choice that we understand. About the Speaker: I am a practicing chartered accountant. My first introduction to mf was in UK in 1992 as an independent financial consultant. Thereafter, in Pakistan, my earliest investment in a mutual fund was in 1995 and since that time I have keenly observed the evolution of mutual funds in Pakistan as an active investor and critic. As a speaker, I believe training is boring but learning is like LG KG 195 - full-time masti non-stop fun. Tell us about yourself…

5. Group Activity Mutual Funds:Financial Reportingand Internal ControlsLet me have the Questions on Your MindDuration: 5 minutes Lets start by noting relevant questions and issues that you believe we must be covering in our session… Example: What are the five most critical issues in preparing financial statements of mutual funds?

6. Who are the main stakeholders in mf? How is financial reporting for mf different from other business entities? Do users actually go through the financial reporting? What is the best measure for evaluating performance of a mf? What is the role of regulators in improving financial reporting of mf? Why mf are not so popular in Pakistan? Mf: Financial Reporting and Internal ControlsKey Questions>

7. Name the best Fund available right now? What are the major issues in internal control of an asset management company? Is it possible to comprehensively discuss this topic in the alloted time? Is it possible to make the financial reporting – external and internal – more meaningful? What is the point of holding this session? Mf: Financial Reporting and Internal ControlsKey Questions>

8. Is the financial reporting of mf done with user in mind? Every bank now appears to have an asset management company of its own. What should be done to resolve conflict of interest in such situation? Is it true that the mf are managing their equity portfolios much more actively than in past? As a result, they trade on day to day basis and KSE is much more volatile than before because of limited float. Should there be a separate financial reporting standard for mf? Mf: Financial Reporting and Internal ControlsUser Issues and Perception>

9. Session 1: Overall view of mf Session 2: Financial Reporting Session 3: Internal Controls and Fraud Prevention in mf Session 4: Review and Conclusion Course Objective: Discuss the financial reporting practices and practical issues in financial reporting. Provide an outline for possible solutions. Sharpen our understanding of operational internal controls of mf. Focus on investment policy, its interpretation, application, and controls. Course Organisation

10. mf: basic business model • A mutual fund is a collection of stocks, bonds, or other securities purchased by a pool of investors and managed by an asset management company.

11. Close-end Funds Open-end Funds Additional Notes: Employee Provident Fund, and Pension Schemes are also a kind of mutual fund managed by trustees on behalf of members. Income Equity Balanced Index Tracking Islamic: Income, equity and balanced Sector Fund of Funds REIT Pension Funds Mutual Funds: Classification

12. Asset Management Companies NIT JS PICIC Almeezan AKD Arif Habib Atlas BMA PICIC BMA Askari IGI National Fullerton Dawood How Mutual Funds have evolved in Pakistan? Investment Corporation of Pakistan and National Investment Trust were pioneers in establishing close-end and open-end mutual funds. Presently open-ended mutual funds stand at Rs. 325 b [Feb-2008]. The market cap of close end mutual funds was Rs. 36.24 b [11-4-08]. Out of Rs. 325 b open end funds, Rs. 124 b [38%] were in equity funds, and Rs. 127 b [39%] were in income fund. Courtesy: Monthly Mutual Fund, A Financial Daily publication, Editor: Mr. Amir Ashray. Mutual Funds in Pakistan: Major Players

13. USA: In 1998, for the first time in history, total assets of mutual funds exceeded the total assets of all the nation’s banks. USA: There are more mutual funds than listed companies. Mutual Funds: International

14. Non-Banking Finance Companies and Notified Entities Regulations 2007 Close-end mf to be converted into open-end scheme: Certificate holders to decide in meeting to be held within five years [Regulation 75]. Accounting issue: Whether the amc should consolidate their mf holdings in its financial statements. Close-end mf now deduct 10% tax at source on dividend payments. Mutual Funds: Recent Happenings

15. Why should I invest in a mutual fund at all? Should I invest in an open end or close end mf? Should I invest in this one or that one? Tell me about the best performing Fund? Advantages of mf for an investor: Daily publication of net asset value Time limit for declaring financial results Low betas and volumes [close-end] Available at lower of nav [close-end] Professional management Ease of redemption Investors and Mutual Funds

16. ‘Mutual funds are still a mystery to many investors’ ‘The advent of one mf after the other has resulted in increased votality at KSE’. Disadvantages of mf for an investor: Multiple charges [open-end: front load, back load]. Offering-redemption spreads Management fee related to assets managed, not performance. Information gaps. E.g. performance comparison with benchmark. Investors and Mutual Funds:What is your take on the following:

17. Basic Accounting Concepts • Assets = Liabilities + Equity • Book value = net asset value = asset – liability = equity • Return on investment is made up of capital gain and dividends. • Capital gain is made up of realised and unrealised capital gain.

18. Financial Reporting of Mutual Funds • External • Internal

19. Approved accounting standards International Accounting Standards. International Financial Reporting Standards. Trust Deed The Non-Banking Companies Finance Companies [Establishment and Regulations] Rules 2003. The Non-Banking Finance Companies and Notified Entities Regulations 2007. The Asset Management Company Regulations 1995. Directives issued by the SECP. So what happens in case of a conflict? Open-end Funds Close-end Funds External Financial Reporting Framework

20. Open-end Close-end The difference between certificates and units… First Quarter Second Quarter + Half-yearly. Third Quarter + Three Quarters Annual Report External Financial Reporting

21. Fund Manager Report Report of the Trustee Independent auditors’ report Statement of Assets and Liabilities Income Statement Distribution Statement Statement of Movements in Net Asset Cash Flow Statement Statement of Changes in Equity Statement of Accounting Policies Notes to the Accounts Income Statement of AMC Additional Information in Annual Report Scheme’s Information Vision Statement Mission Statement Directors’ Report Results for last six years. Statement of Certificates held by directors and management. Pattern of holdings Categories of holdings Statement of Ethics and Business Practices. Core Values Statement of compliance with Code of CG. Review report by auditors for compliance with the best practices of CG. External Financial ReportingClose-end Funds: Contents

22. What is there? Investment Advisor Board of Directors Audit Committee Trustee Bankers Auditors Legal Advisor Registrar Rating Best Practices & Notes: Model Annual Report of a Close-end MFFund’s Information

23. What is there? Investment Advisor Board of Directors Audit Committee Trustee Bankers Auditors Legal Advisor Registrar Rating Best Practices & Notes: BOD. Identify the non-executive directors [also refer to Statement of Compliance…] BOD. How about stating the date of appointment of directors? Investment Committee. The core activity of a mf is investment. Who is managing the process? Rating. There are two type of ratings. Disclose which one is stated and what it means? Model Annual Report of a Close-end MFFund’s Information

24. What is there? Golden Arrow:’To set a standard of investing in better performing and result oriented securities by adopting best business practices and ethics’. Pakistan Strategic Allocation Fund: ‘To deliver enhanced returns from the capital market by combining investment decisions based on fundamental equity research and asset allocation based on quantitative disciplines so as to benefit from value investing as well as from price volatility and market inefficiencies. Best Practices & Comments: 1. Model Annual Report of a Close-end MFMission Statement

25. What is there? Not all the close end funds hold agm. Two funds that hold the agm are AlMeezan Mutual Fund Golden Arrow Best Practices & Comments: Certificate holders should be provided a forum to discuss with the management. We know how agms are conducted in this part of the world, but with all its limitations, its better to have it. Model Annual Report of a MFNotice of Meeting

26. What is there? Golden Arrow:’To set a standard of investing in better performing and result oriented securities by adopting best business practices and ethics’. Pakistan Strategic Allocation Fund: ‘To deliver enhanced returns from the capital market by combining investment decisions based on fundamental equity research and asset allocation based on quantitative disciplines so as to benefit from value investing as well as from price volatility and market inefficiencies. UTP A30+ Fund: ‘Pursuit of professional excellence’. Best Practices & Comments: Al Meezan Mutual Fund: ‘To be the leading mutual fund in the industry, outperforming the benchmark on a consistent basis, and providing shareholders with the best combination of current income and future growth on a risk adjusted basis’. Model Annual Report of a Close-end MFMission Statement

27. What is there? Profile Investment strategy Fund performance Income distribution Corporate governance Attendance of Board Meetings Insider trading External auditors Outlook Commitment Acknowledgements Best Practices & Comments: 1. Model Annual Report of a MFReport of the Directors of the Investment Advisor

28. What is there? Performance table discloses the performance of a fund over say last 10 years. AMMF is the only fund to do so. Best Practices & Comments: It is important for the users to see performance over long term. Possible reason for non inclusion: Some funds do not have a track record of longer duration. Model Annual Report of a MFPerformance Table

29. What is there? Most equity funds use KSE 100 as a benchmark. Golden Arrow: ‘The KSE 100 started the year at 9,989 and close it at 13,772 gaining 37.87% during the period’. Best Practices & Comments: Use of KSE 100 as a benchmark is not totally correct as most funds are not restricted to invest in KSE100 only; infact KSE All index may be more appropriate. For balanced fund, most do not specify benchmark return at all. I wonder why dividend yield of KSE 100 is not added to the capital gain. Model Annual Report of a MFBenchmark

30. What is there? Golden Arrow: ‘The KSE 100 started the year at 9,989 and close it at 13,772 gaining 37.87% during the period…the fund returned 44.70% during the year...the NAV at Rs. 7.86 rose to Rs. 10.65…including Rs. 0.50 per share dividend’. Rs. 7.86 – 0.50 = 7.36 Rs. 10.65 – 7.36 = 3.29 Rs. 3.29 / 7.36 = 44.7% Best Practices & Comments: Quite rightly, dividend paid out of the income of last year but not reflect in the financial statements of that period is reduced from opening nav. Model Annual Report of a MFPerformance Evaluation: Example 1

31. What is there? PSAF: ‘PSAF delivered a NAV-based total return of 26.49% compared to 37.87% returns by the KSE 100 index during 2007’. Best Practices & Comments: A straight forward statement of fact. However, no support of how 26.49% has been computed, is provided. Opening nav = 13.30 Closing nav = 13.60 Adjusted opening nav = 13.30 – 2.50 = 10.8 Eps and unrealised gain on available for sale investments = 2.8 Change in nav = 2.8 / 10.8 = 25.93% The return figure stated is not correct. Model Annual Report of a MFPerformance Evaluation: Example 2

32. What is there? AMMF: ‘AMMF recorded a NAV-based return of 27% versus market return of 17.16% as measured by Dow Jones JS Pakistan Islamic Index. [ 37.87% returns by the KSE 100 index during 2007]. Best Practices & Comments: I wonder if the choice of bench mark is appropriate. Opening nav = 16.96 Closing nav = 18.55 Adjusted opening nav = 16.96 – 3 = 13.96 Eps and unrealised gain on available for sale investments = 4.59 Change in nav = 4.59 / 16.96 = 27.06% The return figure stated is correct. Model Annual Report of a MFPerformance Evaluation: Example 3

33. What is there? Pakistan Stock Market Fund: ‘During the twelve months PSM delivered a total return of 29.41% compared to the KSE 100 index appreciation of 37.87%. PSF:’The Board…has already declared distribution in the form of bonus units to A class units and equivalent cash for B class units at a rate of Rs. 25 per unit. The bonus of Rs. 25 per unit is 29.66% on the opening NAV for FY 2007’. Best Practices & Comments: The statement is not supported by any computation. There is no requirement of ‘per certificate statement of movement in reserves’ for open end funds. This makes it even more difficult to validate claims about returns of open end funds. Model Annual Report of a MFPerformance Evaluation: Example 4 Open end

34. All the close end mf are available below their nav. For example on 13-3-08, First Dawood Mutual Fund at Rs. 8.20 [nav = 14.51, discount 43%], PICIC Growth Fund at Rs. 31.45 [nav = 50.57 discount 40%]. Why? Possible explanations: The dividend yields of these funds is not compatible with the market. All earnings are not available for distribution. Because they under perform the market. They are not popular because of low betas and low turnover. Close-end MF: Why its market value consistently remains below its nav?

35. What is there? Fund performance Market performance Economy Fund activity Future outlook Best Practices & Comments: I think that a lot of information provided in the Fund Manager’s Report is largely unrelated to the performance of the Fund. It is true that national macro variables affect portfolio. However, is it what user is looking for. Model Annual Report of a MFFund Manager’s Report

36. What is there? UTP A30+ Fund: ‘JS ABAMCO Limited the management company of UTP A30+ Fund has in all material respects managed UTP A30+ Fund in accordance with the provisions of the Trust Deed dated December 26, 2005 of UTP A30+ Fund and Non-Banking Finance Companies [Establishment and Regulations] Rules, 2003, during the period from July 1, 2006 to June 30, 2007’. Best Practices & Comments: 1. Model Annual Report of a MFReport of the Trustee

37. What is there? PSAF: ‘At present the Board includes six non-executive directors however, none of the directors on the Board represent minority shareholders’. Best Practices & Comments: There is no representation of minority shareholders on Board of any Fund. None of the funds identify the non-executive directors on its Board. Should it be done? Where? Model Annual Report of a MFStatement of Compliance with Best Practices of Code of Corporate Governance

38. What is there? Standard Wording: ‘Based on our review, nothing has come to our attention, which causes us to believe that the statement of compliance does not appropriately reflect the company’s compliance, in all material respects, with best practices contained in the Code of the Corporate Governance as applicable to the Company for the year ended June 30, 2007’. Best Practices & Comments: The language needs a change. Double negatives are against any basic rule of communication. I see this report more as a waste of precious space that may be devoted to more meaningful information. Or is it that auditors do it to justify the additional fees? If I were to do it:: ‘Based on our review, we believe that the company has complied with the Code of the Corporate Governance in all material aspects during the year ended 30 June 2007’. Model Annual Report of a MFReview Report to the certificate holders on statement of Compliance with Best Practices of Code of Corporate Governance

39. What is there? Assets Liabilities Net assets Shareholder’s equity Best Practices & Comments: 1. Disclosing nav per certificate at the bottom. AMMF did so for 2006 when I suggested in 2005 agm. However, its again the same in 2007. Model Annual Report of a MFStatement of Assets and Liabilities

40. What is there? Income Expenses Net income for the year Earning per share Best Practices & Comments: Income is stated as one liners. Gain on sale of investment is shown as a net figure. Losses are not disclosed by any mf. Dividends. It is not possible to figure out the no-dividend scrip as dividend is disclosed as one liner. Dividends. There is no mention of dividend yield at all anywhere in the report whereas it is the bed rock of earning of a stable portfolio. Model Annual Report of a MFIncome Statement

41. What is there? Expense per certificate for selected close end funds Pakistan Premier 2007 = 0.42 2006 = 0.47 Pakistan Strategic Allocation Fund 2007 =0.45 2006 = 0.56 AMMF 2007 = 0.40 2006 = 0.47 Golden Arrow 2007 = 0.25 2006 = 0.19 Best Practices & Comments: Management charges amounts upto 80% of the total expenses, followed by brokerage upto 20%. Certificate holders of close end mf pay anywhere from 2.5% to 5% as expenses, which appears to be on a higher side. AKD Index tracker fund is probably the cheapest. For open ended funds, computing expense per unit is difficult because of purchase and redemption of units. Model Annual Report of a MFIncome Statement: Expenses

42. What is there? This statement simply shows movement in the unappropriated income account, normally because of payment of cash dividend. See AMMF, PPF, Golden Arrow, PSAF Best Practices & Comments: There is no point of preparing this statement when the same information is provided in the statement of changes in the equity. We must state that some funds do not prepare soce e.g PPF and PSAF. Model Annual Report of a MFDistribution Statement

43. What is there? This statement simply reconciles the opening nav per share with the closing. Change in nav is normally because of eps and distribution. EPS for the year is added to the opening nav. Distributions made during the year, even those relating to the previous year, are deducted from it. Best Practices & Comments: This is just about the only statement that I see in the accounting literature that translates absolute figures into something one can relate to. The data here is used for computing % change in nav and comparing it with benchmark. Model Annual Report of a MFStatement of Movement in Equity and Reserves per share [certificate]

44. What is there? Cash flows from operating activities Cash flows from financing activities Net increase / [decrease] in cash and cash equivalents Opening cash balance Closing cash balance Best Practices & Comments: Cash to investment conversion and vice versa is the most critical aspect of any fund. Its a disappointment to see cash flows from operating activities being prepared on indirect method which discloses change in investment as a one liner. Management hold auditors for doing so, whereas its them who prepares the f/s. I think not many know how to do it. F/s of JS Funds provide figures of sale and purchase of investments. Model Annual Report of a MFCashflow Statement

45. What is there? Legal status and nature of business Basis of presentation Statement of compliance Summary of significant accounting policies Best Practices & Comments: How about preparing a separate statement called ‘Statement of Accounting Policies’ and including this stuff there. This will allow the preparers to start notes to f/s from serial number 1. Model Annual Report of a MFNotes to the Financial Statement

46. What is there? Bank balances Investment in marketable securities ‘available for sale’. Investment in marketable securities ‘held for trading’. Derivative financial instruments Deposits and receivables Best Practices & Comments: The core activity of a mf is investments. In simple terms, its about cash-to-investments and investment-to-cash. We will discuss outline of investments here and take it up later in detail. Model Annual Report of a MFNotes to the Financial Statement: Assets

47. What is there? Payable to investment advisor Payable to Trustee [custodian] Payable to SECP Accrued expenses and other liabilities Best Practices & Comments: No computation is provided about how the amount has been arrived at for payments to investment advisor, trustee or SECP. Possible reason: the amount of computation is an average of six months. Good one? Model Annual Report of a MFNotes to the Financial Statement: Liabilities

48. What is there? The only expense having the privilage of a five line disclosure is…..auditors’ remuneration. In most cases it varies between 1-1.5% of expenses, not income. Best Practices & Comments: I like mf also because of mandatory change of auditors after five years. This policy is a model that should be emulated in all the sectors. Other services should be restricted. Joint auditors should be appointed. Model Annual Report of a MFNotes to the Financial Statement: Expenses

49. What is there? It is good to see that audit committees are in place. Mandatory rotation of auditors is another positive point. Best Practices & Comments: 1. How about a charter and report of audit committee and a record of its attendance to be included in the annual report. Model Annual Report of a MFAppointment of Auditors

50. What is there? This is computed as per IAS devoted on earnings per share. Best Practices & Comments: 1. Eps accounts for the change in nav per share [certificate]. Model Annual Report of a MFEarning per share [certificate]