Money Market Fund Potential Accounting Impacts
What are the potential accounting impacts of the SEC's proposed rules? Should the SEC require organizations to report the stable NAV but also track and disclose the Shadow NAV? Should the SEC require organizations to report the floating NAV?
Generally the following reporting issues may present themselves as a result of this rule change:
Rule 2a-7 gives a money market fund (MMF) the ability to maintain a stable net asset value per share by permitting them to use the amortized cost method of valuation. Currently, rule 2a-7 defines the amortized cost method as the method of calculating an investment company's net asset value per share ("NAV") whereby portfolio securities are valued at the funds' acquisition cost as adjusted for amortization of premium, or accretion of discount, rather than at their value based on current market factors. Under the amortized cost method, portfolio securities generally are valued at cost plus any amortization of premium or accumulation of discount. The basic premise underlying MMFs' use of the amortized cost method is that high-quality, short-term debt securities held until maturity eventually will return to their amortized cost value, regardless of any current disparity between the amortized cost value and market value, and would not ordinarily be expected to fluctuate significantly in value. Thus, the rule permits these funds to be valued in this method as opposed to market value so long as the deviation between the two remain minimal, and results in the computation of the share price that fairly represents the current net asset value per share of the fund.
Because of the nature of MMFs, these funds generally are classified on the balance sheet as cash equivalents. Examples of items commonly considered to be cash equivalents are: Treasury bills, commercial paper, and federal funds sold (for an entity with banking operations).
Cash equivalents are defined in FASB's Codification under section 305-10 as short-term, highly liquid investments that have both of the following characteristics:
- Readily convertible to known amounts of cash
- So near their maturity that they present insignificant risk of changes in value because of changes in interest rates.
Generally, only investments with original maturities of three months or less qualify under that definition. Original maturity means original maturity to the entity holding the investment.
MMFs unquestionably received the cash equivalent treatment because of characteristic (i.e., characteristic "b" as mentioned above). The amended rule requires a filer to show, on face or through disclosure, the difference (if any) between the reported stable NAV and the shadow NAV. A significant difference in the auditor's perception may call into question whether the MMF can still be considered a cash equivalent. This is in addition to the requirement to move to a Weighted Average Life (WAL) model to 120 days (outside of the three months general rule for cash equivalents.) Auditors might be exposed to greater risk as variances between the stable NAV and shadow NAV become more than insignificant and thus be more inclined to question this issue before signoff.
Fed and Treasury intervention in the short-term markets back in 2008 called to question the stability of the money markets in part due to losses sustained as a result of Lehman's issued debts securities and exposure to debt securities issued by structured investment vehicles. Up until this point, there was no question that an investor would generally recoup the funds they invested.
If the SEC requires the shadow NAV disclosure valuation, issues may arise in the case where: (1) there is more a significant change, or that change becomes negative; (2) using the stable NAV as appropriate measurement of the cash equivalent is called into question; and (3) MMFs are required to be reclassified as available-for-sale (AFS) securities. (Of course these scenarios are all hypothetical specific action or inaction and would depend on negotiations between a company and its auditors.)
Reporting the floating NAV as previously vetted by the SEC but not carried forward in these rule changes would not be an issue in this case, as the floating NAV is more akin the true market value of the MMF at the reporting date.
Temporary changes in the MMFs value would not trigger an accounting event as these funds are currently carried as cash equivalents at an amortized cost. Only in the event that these funds no longer qualify for this accounting classification and, they are moved into that investment category, would this issue present itself. Even then, only declines in fair value below the amortized cost basis considered other than temporary impairment would require the filer to write down the investment.
Moving to a floating NAV would certainly require rethinking where the market changes would flow-through earnings or possibly other-comprehensive-income (OCI). However, it appears that it is the SEC's intention is to keep the current classification intact as it took the discussion of floating NAV out of the new guidance.
Keep in mind that all rules are subject to interpretation by the SEC, the filer, and their auditor.