Accounting, Valuation & Taxation

Ten per cent of the paper, and the unit that needs a warning before anything else: the tax rates and thresholds here are set by the Finance Act and change. Learn the mechanism — how a gain is classified, what makes a scheme equity-oriented — and check the current year's rates separately. A distributor quoting last year's number is giving wrong advice, however confidently.

How is NAV computed?

Take everything the scheme owns — securities at their current value, plus accrued income and cash. Subtract what it owes, including accrued expenses. Divide by the units outstanding. That is the NAV, and it is worked out at the end of every business day.

Securities are valued mark to market: at what they are worth today, not what the scheme paid for them. This is why NAV moves even when the fund manager does nothing at all. It is also why NAV is a measure of value rather than of performance — to judge performance you need two NAVs and the time between them.

What does the expense ratio do?

Running a scheme costs money: the management fee, custody, registrar charges, audit, marketing, and distributor commission where there is a distributor. Those costs are charged to the scheme, and the total is expressed as the total expense ratio, a percentage of net assets.

The part that matters for the examination and for explaining it to an investor is that it is charged daily and is already reflected in the NAV. Nobody sends the investor a bill. The return an investor sees is a return after expenses, which is why comparing two schemes on their published returns already accounts for the difference in what they charge.

SEBI caps the ratio, and the cap steps down as a scheme grows — bigger funds must pass some of their scale on. The slabs themselves have been revised more than once, so treat the current figures as something to look up.

How are gains from mutual funds taxed?

A gain arises when units are redeemed, switched or otherwise transferred — not while they are simply held and rising. Switching between schemes counts as a redemption and a fresh purchase, which surprises investors and is a fair examination question.

The gain is then classified as short-term or long-term by how long the units were held, and the holding-period threshold is not the same for equity-oriented schemes as for others. Two things follow from this that are worth holding on to:

• The classification depends on holding period alone. Not on the size of the gain, not on whether the plan was Direct or Regular, not on the investor's income.
• Whether a scheme counts as 'equity-oriented' is determined by how much of it is invested in equity, under the definition in the tax law — not by what the scheme is called.

Income distributions — what used to be called dividend and is now IDCW — are taxable in the hands of the investor. That treatment changed within recent memory, which is exactly the kind of point where an old set of notes goes quietly wrong.

What the examination tends to ask here

About ten questions, split between the mechanical and the tax. The mechanical ones — what NAV is, what mark to market means, where the expense ratio shows up — are stable and worth being certain of. On the tax side, expect questions on what triggers a gain, what decides its classification, and what makes a scheme equity-oriented, all of which are mechanism rather than rate. If a question does turn on a rate, it is asking about the current year's, so check before the exam.