Advisory
The annual financial statement audit is a major event for finance teams of private fund managers. The audit is a comprehensive test of a fund's financial reporting and operational infrastructure. The audit will test, among many things, sufficiency of accounting records, valuation processes, capital activity, waterfall and carried interest provisions, side letters, tax, general governance procedures, and technical financial statement preparation capabilities.
In most cases, the financial statement audit is a requirement that stems from compliance with the U.S. Securities and Exchange Commission’s (SEC) rules for registered investment advisers (RIAs). RIAs managing private funds are subject to Rule 206(4)-2 under the Investment Advisers Act of 1940, commonly referred to as the “Custody Rule”. Even where the fund’s offering documents do not specifically require an audit, RIAs generally satisfy requirements of the Custody Rule by engaging an independent public accountant to perform an annual audit in accordance with U.S. generally accepted auditing standards and distributing audited financial statements to investors. For most private funds, audited financial statements must be delivered within 120 days of year-end, while fund-of-funds generally have up to 180 days.
In this article, I will walk through some key concepts regarding audits of investment companies that I encounter as part of my job assisting private fund CFOs with the annual audit process.
AUDITOR HOT TOPICS FOR INVESTMENT COMPANIES
Investment companies must comply with Accounting Standards Codification (ASC) Topic 946 Financial Services – Investment Companies (“ASC 946”). ASC 946 establishes specialized accounting and reporting requirements that differ significantly from those applicable to traditional operating businesses. The objective of ASC 946 is to provide investors with transparent information regarding investment performance and net asset value rather than operating profit.
Under ASC 946 and other important accounting standards, investment companies are required to report investments at fair value, including many investments that might otherwise be consolidated under traditional operating company accounting guidance. For investment company audits, valuation of investments is the foundation of the entire process.
Because of the focus on valuation and net asset value, auditors spend less time focusing on traditional revenue and expense testing than you may have experienced in a more traditional operating company audit. Instead, auditors spend significant time evaluating the valuation process, valuation documentation and related disclosures.
Valuation – A core competency for all finance teams
One of the most important concepts for fund accounting teams is valuation under ASC Topic 820 – Fair Value Measurement (“ASC 820”). Because investment companies report investments at fair value, valuation becomes the most significant audit area. Auditors evaluate not only the resulting values assigned to investments, but also the governance, assumptions, methodologies, and controls used to develop those values.
Audit challenges often arise when management cannot clearly support how the valuation conclusion was reached. Developing a robust valuation process is one of the most important responsibilities of a fund manager because fair value drives a significant portion of a fund's reported net asset value. Auditors devote substantial attention to understanding how management arrives at its conclusions.
Fund managers should not view third-party valuation reports as a substitute for oversight. Auditors expect management to demonstrate ownership of the valuation process by understanding, reviewing, and challenging the conclusions reached by external specialists. In our experience, funds that maintain active valuation committees, documented review procedures, and robust support for key assumptions generally experience more efficient audits and fewer valuation-related inquiries during fieldwork.
Structure – Where strong documentation and interim work saves time
Fund structures also introduce specialized accounting considerations. Many private funds utilize joint ventures (JV), special purpose vehicles (SPV), blocker entities, and other holding structures for legal, tax, financing, or operational purposes. These structures require analysis under ASC 810 - Consolidation (“ASC 810”) and ASC 323 - Investments – Equity Method and Joint Ventures (“ASC 323”). Fund accountants must understand these accounting pronouncements and be able to analyze entity relationships to form conclusions regarding consolidation of downstream entities or variable interest entities (VIEs) where significant influence and ownership rights exist.
One effective way I have helped investment managers avoid surprises during the audit is to evaluate ownership structures long before fieldwork begins. I work with management to maintain up to date organizational charts that clearly identify all entities within the fund structure, including SPVs, blocker entities, joint ventures, feeder funds, and affiliated companies. We review governing agreements, ownership schedules, and analyses supporting consolidation or equity-method conclusions and perform consolidation analysis that is then readily available for auditor review.
Financial Statement Preparation – Where expertise matters
Financial statement disclosures play a critical role in fund reporting. ASC 855 - Subsequent Events, ASC 450 - Contingencies, and ASC 275 - Risks and Uncertainties, among several others, are accounting concepts that should be considered when preparing GAAP-compliant financial statements. Auditors evaluate disclosures related to fair value measurements, related-party transactions, concentration risk, commitments and contingencies, subsequent events, and significant accounting estimates.
One of the most effective ways to improve audit efficiency is to establish a dedicated financial reporting function. Typically, the fund administrator or an external provider will be responsible for preparing the financial statements. I recommend fund managers evaluate the strength of their financial reporting team to ensure the initial draft of financial statements is worthy of auditor scrutiny. Experienced financial reporting professionals provide value not only through technical accounting expertise, but also through their familiarity with industry practice. Having worked with multiple audit firms and investment fund structures, they understand the types of support auditors typically request, the disclosures commonly expected within the industry, and the areas most likely to generate audit comments. This experience allows management to proactively address issues before fieldwork begins rather than reacting to them during the audit process.
Interim Planning and Audit Readiness
A successful audit begins well before year-end. During interim planning, auditors seek to understand any updates to the fund's organizational structure, investments, valuations and related party transactions. Auditors will often begin testing selected transactions and reviewing supporting documentation for significant activity that occurred during the year, saving significant time at year-end to focus on polishing the financial statements rather than substantive audit testing.
Fund managers should expect auditors to focus on several key areas during interim procedures, including investment purchase and sale documentation, capital contributions and distributions, related-party transactions, ownership structures, debt arrangements, governing agreements, and valuation methodologies. Preparing these items in advance allows management to address documentation deficiencies and accounting questions before year-end reporting deadlines become more compressed.
Perhaps the greatest benefit of interim testing is efficiency. By completing a portion of the audit work before year-end, auditors can reduce the amount of testing required during fieldwork, allowing management to focus on closing the books and preparing the financial statements. Funds that fully leverage interim procedures experience a more streamlined audit process and fewer last-minute surprises.
Legal and Investment Confirmations
Confirmations are often of the most time-sensitive aspects of a fund audit. Unlike internal schedules and accounting records, confirmations require responses from third parties whose timelines are largely outside management's control. As a result, a single unresponsive custodian, lender, attorney, or portfolio company can delay an otherwise completed audit.
Depending on the fund's structure, auditors may seek confirmations from banks, custodians, lenders, brokers, administrators, legal counsel, portfolio companies, and other counterparties. Legal confirmations are particularly important because they assist auditors in evaluating litigation exposure, contingencies, contractual disputes, and other matters that may require disclosure in the financial statements.
Well organized finance teams will begin preparing confirmations before fieldwork begins. Best practices include identifying all anticipated confirmations early, verifying contact information, communicating expectations to third parties in advance, and assigning an internal team member to monitor response status throughout the audit. Funds that proactively manage the confirmation process are able to avoid it causing audit delays and report issuance bottlenecks.
Financial Statement Quality Control
Many first-time audit clients assume the audit is substantially complete once fieldwork concludes. In reality, audit firms typically perform multiple layers of QC before issuing the final report. This process includes manager review, partner review, technical consultations, independence confirmations, disclosure reviews, and final quality assessments. While these procedures occur largely behind the scenes, clients should understand that completing fieldwork does not necessarily mean the audit report is imminent. Appreciating this process can help managers set realistic expectations with investors and other stakeholders.
Audit Post-Mortem
One of the most underutilized opportunities in a first-year audit is the post-audit review. After completion of the audit, management should meet with both internal stakeholders and auditors to evaluate what worked well and what created challenges. Discussion areas often include documentation quality, valuation support, accounting analyses, administrator performance, audit request management, and financial statement preparation.
Conclusion
In my experience, the annual audit is a time consuming and frustrating time for many fund accountants. That being said, I hope this article provided some useful best practices that can help streamline the process, enhance controls, improve documentation and establish a strong financial reporting foundation.
For more information about the Audit Process, please contact Caroprese via e-mail to info@caroprese.com.
About the Author
Garrett Perez, CPA, is a Manager in Caroprese & Company's Advisory Services practice. He specializes in outsourced accounting, financial reporting, due diligence, and audit support, helping clients strengthen financial operations, meet reporting requirements, and provide practical accounting and advisory solutions.
