Auditing Alternative Investments

Presented By: Michael McNee, CPA

January 9th and January 16th of 2008

2

AICPA Practice Aid. What authority does this document have?

• Issued to provide auditors with information that may help them improve the effectiveness and efficiency of their audits and practices and is based on existing professional literature and the experience of members of AICPA’s Alternative Investments Task Force

• Not approved by any senior technical committee of the AICPA

• Publication was reviewed by the AICPA Audit and Attest Standards staff and published by the AICPA, and is presumed to be appropriate

3

What is an alternative investment?

• An investment for which a readily determinable fair value does not exist (not listed on an exchange)

• Includes:

– private investment funds

– hedge funds

– private equity funds

– real estate funds

– venture capital funds

– funds of funds

Disclaimer… neither instructor is an investment advisor or an expert in the strategy of whether the investments should be or to what extent these funds can be utilized.

4

What factors are likely to impact the auditor’s risk assessment process?

The auditors risk assessment is based on JUDGMENT and is unique to eachengagement.

Factors to consider are:

1. The dollar amount of the alternative investments to the total investments, total assets and to total net assets

2. The complexity of the investment including the liquidity of the underlying investments

3. The nature and extent of management’s process and their internal control structure surrounding how they value the investments REMEMBER – THE FINANICAL STATEMENTS BELONG TO MANAGEMENT AND THE AUDITOR’S ROLE IS TO EXPRESS AN OPINION THEREON

4. The nature and extent of information available to management to support the valuation process

5

What are the important audit assertions addressed by this practice aid?

• Existence

• Valuation

6

How can we be sure the investment exists at the balance sheet date?

• Confirmation with fund manager (# of units held, percentage of ownership)

• Reviewing contracts/agreements

• Receipt of a year end statement

• Transactions close to year end date

Does confirming investments in the aggregate satisfy the assertion ofexistence?NO, however confirming investments on a security by security basisTYPICALLY WOULD provide adequate evidence for the existence assertion

7

Is it realistic to…

expect to receive a confirmation letter that would provide adequate audit evidence, and if not, how does that impact the procedures that should be performed?

• Even if the auditor is uncertain about the likelihood of the investment manager providing an adequate confirmation, it does not obviate the auditors responsibility to obtain adequate audit evidence. The auditor must perform alternative procedures, such as:

– Understanding management’s internal control structure…. What steps does management perform to understand the nature and valuation of the investments, (do they make site visits or phone calls), how do they document it?

– Review investment agreements, (limited partnership agreements, contracts, etc.)

– Review statements from trustee and compare to amounts recorded on the books

– Compare cash receipts to investor/trustee statements

– Determine if there is an investment committee of the Board and their knowledge level/background

8

What valuation methods can be used?

• Cost (subject to rules on impairments that are other than temporary)

• Equity

• Fair Value

Organizations that have increases in fair market value (investment gains) aregoing to want those gains to be reflected in the financial statements. Therefore, the auditor is presented with the challenge of trying to meet the valuation assertion of verifying evidence regarding fair value.

9

How can the auditor overcome this challenge?

Remember, it was stated earlier that it is Management’s responsibility to provide a valuation and related Internal Control structure.

Management cannot, under any circumstances, assign or outsource this responsibility to a party outside of Management.

Management can look to the fund manager for guidance in the valuation, however management must have sufficient information to be able to independently evaluate and challenge the valuation.

10

Is this any different than when management is asked to make representations to the auditor in the representation letter?

Although management may not have CPA’s on staff that are experts in GAAP reporting they must have enough of an understanding to take responsibility for GAAP financial statements. How does management overcome this hurdle?

The auditors should sit down and explain the financial statements, both during the year as unusual transactions occur and again at the end when the financial statements are being reviewed before finalization.

Management must sit down with investment/fund managers so that they can understand the investments and valuation techniques!

The auditor’s procedures should include auditing managements’ internal controls over the above.

11

Appendix 2

Appendix 2 gives examples of due diligence, ongoing monitoring and financial controls that the investor (our nonprofit client) should take.

Initial Due Diligence– Face to face meetings with investment team– On-site visits– Documentation by investment staff including offering memoranda, contracts,

financial statements– Evaluate how the allocation fits with overall portfolio– Solicit information about the investment manager from knowledgeable third

parties– Perform reference checks

12

Additional Examples

Additional examples of due diligence, ongoing monitoring and financial controls that the investor (our nonprofit client) should take:

Ongoing Monitoring

– Conduct regular meetings with investment advisor

– Attend annual meeting or perform annual site visit

– Review audit reports where available, note the opinion, method of valuing underlying investments

– Review other communications such as quarterly shareholder letters

– Compare investment statements to the books

– Obtain SAS 70 reports (if available)

– Perform and test check valuations

– Review press reports/media for negative publicity

13

Additional examples

Financial Controls– Maintain a formal investment policy approved by the Board outlining strategies

and risks– Have an investment committee that is responsible for oversight of investments– Continually update a listing of alternative investments by fund manager

including the underlying investments contained– Review audit reports– Compare amount per investment statements to the general ledger

The auditor would test management’s internal control system to determine the extent of substantive tests to be performed

14

What other challenges are we faced with regarding the valuation assertion?

• How does the due diligence performed by management link to the valuation assertion?

• Does management have access to the underlying investments?

• Does management understand the underlying investments?

• How liquid are the underlying investments?

• Do the underlying investments themselves have readily available market values?

• What happens if management can not obtain a list of the underlying investments?

15

What should the audit approach consist of?

• Identify risks

• Assess risks

• Design procedures to reduce risks to acceptable levels

Factors to be considered:

• The nature and complexity of the alternative investments

• The percentage of alternative investments to both total assets and the total investment portfolio

16

Increased Risk

As the complexity and percentage of the alternative investment increases, so does the audit risk. More audit work must be performed and audit evidence should be obtained.

• Having a listing of underlying investments that are in securities that have readily available market values would decreases risk

• Having a listing of underlying investments at a date other than year end may provide value. However, it is not as strong as having that information at year end but could provide evidence to help reduce risk

• The inability to obtain a list of underlying investments detracts from the quality of audit evidence and could be problematic

• Having an audited financial statement by a reputable firm, with the same year end date as the organization would provide stronger evidence and decrease risk

The evaluation of the evidence and the assessment of risk are subject to auditors’ judgment

17

Post-Evaluation

After evaluating the internal control environment and reviewing whether management has taken the steps outlined previously or other steps, the auditor can determine the nature, timing and extent of procedures to be applied, just as they would with any other specific account balance or class of transactions.

Steps that can be performed to achieve the valuation assertion for investments that are stated at fair value are as follows:

Confirm the alternative investment – However, the guidance in AU section 328, paragraphs .26 through .39 state that even the confirmation of securities on a security-by-security basis does not, in and of itself, constitute adequate audit evidence with respect to the valuation assertion.

Review and test the investor entity’s assumptions and the underlying data from the fund manager. The confirmation may provide information that was used by the investor’s management in the valuation process.

18

Additional Steps

Additional steps that can be performed to achieve the valuation assertion for investments that are stated at fair value:

• Review audited financial statements. If at the same date, reconcile the audited financial statements. Obtain information on fair values from the audited financial statements. In situations of low or moderate risk (the amount of the investments are not that material, other controls are strong), these procedures may be enough

• Review interim financial statements and test managements tracking analysis

• Review transactions such as distributions at or near year end dates

• Review transactions subsequent to year end date to determine that there were no significant price declines that may have existed at the balance sheet date

19

Additional Steps

• Obtain management representations about:

– the reasonableness of significant assumptions

– whether the assumptions appropriately reflect management’s intent and ability to carry out specific courses of action

– appropriateness of the measurement methods

– consistency of application

– completeness and adequacy of disclosures

– subsequent events requiring adjustments to fair value

20

Summary – What does this all mean?

At the end of the day, how comfortable are you with the audit work performed?

• Are significant risks properly disclosed in the financial statements? If not an opinion modification may be required?

• Are the investments so large, complex and illiquid that an emphasis of a matter paragraph would be useful? For these purposes, this alludes to other than an unqualified opinion, but perhaps needs to be considered.

• Is the audit evidence sufficient to provide a reasonable basis for forming an opinion? If not, consideration must be given towards a modification of the standard auditor’s opinion

If the answer to these questions leads the auditor towards modifying his or her standard report due to a scope limitation for the ability to satisfy the valuation assertion, consideration should be made to reporting on the cost basis.

21

Contact Information

• Michael McNee, CPAPartner-in-Charge of Nonprofit and Government Industries GroupMarks Paneth & Shron LLP622 Third AvenueNew York, NY 10017212-503-8954mmcnee@markspaneth.com