Financial accounting deals with extraordinarily complex issues, but its purpose is quite simple: to communicate economic reality. The accounting profession's body of knowledge generally accepted accounting principles--permits dissimilar organizations to apply the same standards in presenting financial results. The performance of businesses as dissimilar as banks, factories and hospitals can be compared consistently from one period to the next.
Because GAAP financial statements have significant predictive value, interested parties can track trends in sales or revenues, dividends, retained earnings and book values. In one area, however, GAAP is ineffective for the principal end users of financial information. These accounting principles, developed for companies with financial statements based on historical cost accounting, should not be applied to mutual funds. GAAP statements do not depict economic reality for mutual funds; funds operate primarily on a market value and tax basis and shareholders would be better served by a different financial reporting approach. In the square peg in a round hole analogy, mutual funds are the square peg and GAAP is the round hole.
There is a square hole mutual funds fit into naturally: tax-basis accounting. It's time to modify GAAP significantly for mutual funds and account for their income exclusively on a tax basis. A substantial majority of mutual fund financial executives say preparing tax-basis financial statements for mutual funds would provide many advantages over GAAP. Almost three-quarters of the financial executives in the mutual fund industry surveyed in 1992 by the Investment Company Institute said switching to tax-basiS reporting would provide shareholders with more meaningful financial statements.
Furthermore, the American Institute of CPAs, the Securities and Exchange Commission and the Financial Accounting Standards Board already have recognized the importance of applying elements of tax-basis accounting to mutual funds. The AICPA and the FASB recently endorsed basing mutual funds' return-of-capital distributions reporting solely on tax rules. SEC rules regulate long-term capital gain distributions, exclusively a tax concept. However, these bodies have stopped well short of endorsing a complete change to tax-basis reporting.
Tax-basis reporting would give shareholders the information they want and need in a clear, understandable format. A wide array of book-tax differences would be eliminated. There would be a single, consistent basis for mutual fund accounting instead of two often contradictory and misleading bases.
THE SPECIAL CASE OF MUTUAL FUNDS
Open-end investment companies--or mutual funds--hardly resemble companies that produce goods or services. Depending on their investment objectives, funds can be made up of listed or unlisted common stocks; money market instruments; foreign securities; government, corporate or municipal bonds; or other securities. Most funds are organized as corporations but also may be limited partnerships or business trusts.
Mutual funds are pools of securities that provide investors with diversification, professional management and convenience. They have existed in the United States since 1924. Most of the current accounting rules date to the Investment Company Act of 1940, which mandated SEC registration and recognized the public expected mutual funds to be exempt from federal income tax at the corporate level.
Mutual funds are creations of the tax law; without special tax treatment, few if any could exist. When funds meet certain requirements, federal income taxes on earnings are paid by shareholders only on distributions received from such earnings. Mutual funds thus are tax conduits not subject to the double taxation of companies producing goods or services. Conduit status makes funds attractive investments for individual investors, large and small.
Until the 1980s, mutual funds were fairly simple. …