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How to be successful in audit engagements of your hedge fund.
By Robert A. Green, CPA
An annual audit of a hedge fund is not just a rubber stamp from a licensed certified public accounting (CPA) firm. We CPAs refer to our audit practice as assurance, which is what hedge fund investors are looking for.
Investors fear fraud
Investors have a reason to fear fraud: There’s been plenty of high-profile fraud in the investment management industry from big players like Bernie Madoff and Bayou Hedge Fund Group, to smaller ones, as well. In 2002, the AICPA’s Auditing Standards Board raised the bar on the auditor’s responsibility to consider fraud in a financial statement audit with SAS No. 99: Consideration of Fraud in a Financial Statement Audit.
During the past decade, hedge funds grew exponentially in number, and the media expects them to grow dramatically more over the next five years. Service providers have made it fairly easy and low in cost to start a hedge fund. Investors hunt for returns well above historically low interest rates fueling the trend. Has it also gotten easier to fool investors? In the recent PFG Best fraud, it was easy for the owner to pull another Madoff in doctoring up monthly bank statements and paper audit confirmations with fool’s gold. Advertising requires audited performance records President Obama’s Jumpstart Our Business Startups Act (JOBS) passed in April 2012 promised to lift the advertising restrictions on certain private companies, which for now also includes private hedge funds and private equity funds. Learn more at SEC Proposes Rules to Implement JOBS Act Provision About General Solicitation and Advertising in Securities Offerings. If these rules become fully operational keep in mind there is some blowback you can imagine the floodgates opening over the Internet for investment managers advertising their audited performance records. For the first time, private hedge funds will be able to advertise like mutual funds, opening up the marketplace to new investors as they won’t be limited to first having pre-existing relationships which is the rule now. With advertising performance records, audit reports from quality CPA firms become even more important than ever before. While investors may not know the manager previously under the new rules, they may know and trust the audit firm, as well as other service providers, and that gives them the added comfort they need.
Smaller funds should choose audit firms that best suit their needs
When it comes to choosing an audit firm, bigger doesn’t mean better. Certainly, a big hedge fund needs a big audit firm, but a smaller hedge fund can be better served by a smaller audit firm. Many of the well-publicized undetected frauds of the last decade were perpetrated by big hedge funds audited by big-four audit firms who missed it. It was ridiculous that big funds and broker dealers operated by Bernie Madoff and Russell Wassendorf of PFG and Peregrine could use a one-partner shop audit provider for a very long time. That didn’t make sense. Incubator funds need an audit, too
Since 2000, GreenTraderTax, GreenTraderLaw (now discontinued) and GreenTraderFunds played an integral part in the launch of hundreds of new small hedge funds. Many of them started out as incubator funds, a concept and term we created in the industry. Currently, our CPA firm Green NFH, LLC focuses on providing assurance (audit and other attest services) and tax compliance services to funds, managers and traders. Auditor independence rules prohibit auditors from being involved with development (legal) and accounting services.
An incubator fund is a hedge fund minus compensation and related clauses in the LLC operating agreement to the owner/investment manager. For about one-half the initial legal fees with an outside law firm like Investment Law Group, an incubator fund can put its trading program into operation to generate an auditable performance record, using the managers’ own funds, and in some cases funds from close family and friends, too. (Consult with outside legal counsel about that first.)
An audit of an incubator fund without compensation to the manager and without outside investors is generally less work, which means it also costs materially less than a regular for-profit hedge fund audit with several outside investors.
Choose your auditor early on
Sometimes a manager needs to list his or her auditor in a private placement memorandum or in registration forms. Do pre-audit evaluation early on so you can execute an engagement letter with the audit firm on time.
Your auditor will perform substantial client acceptance procedures in accordance with Generally Accepted Auditing Standards (GAAS). These include background checks, assessments of client integrity and character, contacting key service providers like attorneys and prime brokers, reviewing interim and prior year financial statements, and reviewing financial reporting and accounting systems for auditability. (Green NFH, LLC needs to be sure a client is a good fit for our firm.)
Consider including the stub-period in the first audit period
Many funds commence operations on a date other than the first day of the fiscal year. For example, if the year-end date is Dec. 31, 2011 for a fund that started on Oct. 1, 2011, it may be too costly to have an audit for the three-month period (the stub period). The investment manager may consider a 15-month audit for the period ending Dec. 31, 2012. Factors to consider when making this decision include the provisions of the partnership agreement (or other fund governing documents if applicable) related to annual audits, SEC requirements if the fund advisor is registered with the SEC and state requirements if the advisor is registered with a state. (Consult with our firm about the appropriate length of a stub period. While three months is generally appropriate, six months may be too long.)
An independent auditor may perform tax compliance services
At this point, advisors who set up funds in 2012 are engaging CPA firms for their 2013 stub-period audits. While their audit may be for a period longer than 12 months, their initial short-year 2012 income tax returns must be filed in 2013 the tax man is not patient. (Green NFH, LLC is executing engagement letters now for 2013 stub-period audits, including tax compliance services for 2012 and 2013. It’s good to start working with a new client on 2012 tax compliance services while we commence our audit procedures as soon as possible, earlier in the audit period.)
Audited performance records are different from audited financial statements
These are two different types of audits. Hedge fund private placement memorandum (PPM) and LLC Operating Agreements often call for annual audited financial statements. But, managers also often want to distribute and soon hopefully to advertise audited performance records, which are different from their annual audited financial statements. While CPAs adhere to GAAP in the U.S. for audits of financial statements, audits of performance records are based on different agreed upon procedures. In this case, it’s the CFA Institute’s Global Investment Performance Standards (GIPS). Very few service providers are enabled to do GIPS work. (Consult with our firm about it.)
When are audited financial statements required by regulators versus self-imposed?
SEC-registered (larger) investment advisers operating securities hedge funds and NFA-registered Commodity Pool Operations (CPOs) are required to have annual audits.
State-registered or exempt-from-registration advisers operating smaller hedge funds may not be required to have an annual audit, but most choose to do so to satisfy investor needs. Note that if the advisor discloses the fund will have an annual audit in the private placement memorandum and or other investor documents, then it’s a self-imposed requirement.
PCAOB-registered audit firms
An SEC-registered investment adviser’s hedge funds need to be audited by PCAOB-registered auditors. PCAOB stands for Public Company Accounting Oversight Board. Dodd-Frank financial regulation raised the threshold of funds under management for SEC investment adviser registration. Most smaller hedge funds fall under this threshold they have less than $1 million to less than $100 million under management, and in many states, they may use audit firms that are not registered with PCAOB.
Audits are formal, technical and industry-specific
Investors are looking for assurance from a respected and independent CPA firm with significant experience, qualifications and a good brand name in performing audit engagements of investment management funds and managers. Audit work is dictated by GAAS and industry guides like the AICPA Audit Guide of Investment Companies. Our CPAs have crafted our own proprietary working papers and financial statement templates based on AICPA and other guidance for audits of investment management companies.
Financial statements for hedge funds have different disclosure requirements from those prepared for service companies or manufacturers. Experience in the investment management industry is needed in order to prepare or review the financial statements.
The makings of a successful audit
An audit should be conducted in an efficient and effective manner keeping an eye on cost, but not to the point that it undermines audit quality. Hedge fund audits are often due within 120 days of year-end and auditors are on a strict time schedule. Investors want tax Schedule K-1s well before April 15th so they can prepare their individual tax returns. Hedge-fund income passes-through to them whether they get distributions or not. Tax service providers don’t want to complete their work until the audit is completed. (Green NFH, LLC performs audit and tax compliance services, so there is good efficiency and value).
To best meet this timetable, auditors should perform interim procedures during the year. Tax planning is good to do before year-end and during the development process. (Get started with us in December if you haven’t yet. January may be too late.)
Auditing is not a simple rubber stamp operation It’s a painstaking process, expanded this past year by even more industry procedures and changes in audit guidelines. In this case, why not consider a new audit firm if that’s what you’ve had in mind this year, since your current audit provider can’t just rollover working papers to 2012.
Many small hedge funds use an outside independent accountant for monthly NAV (net asset value) reports to investors, and some owners try to cut corners and do the accounting work themselves. While managers may feel that keeps their costs lower, this can render their financial statements and accounting un-auditable, or it can significantly increase audit testing, which can raise overall costs and problems in the audit. Don’t save a quarter to cost a dollar. The auditor can’t perform accounting work
An auditor must be independent. Auditor independence rules bar auditors from taking responsibility for the preparation of accounting entries or financial statements. During the course of the audit, an auditor may propose adjusting entries or prepare the financial statements, however, the client must acknowledge his or her responsibility for the entries and the financial statements in the management representation letter. A client’s books and records must be substantially complete and current prior to the commencement of the audit. If an auditor performed and took responsibility for the client’s accounting, how could he or she possibly audit his or her own work and also remain independent? That’s the reason for these rules.
Speak with your audit firm early to make sure your operation is auditable in an efficient and effective manner. That involves implementing proper internal controls and other systems to stay on the right track, and not just for your track record. Plan to use a respected outside accounting firm that specializes in hedge fund accounting and a separate audit and tax-compliance service provider (like Green NFH, LLC). An auditor can’t set up internal controls for a client; the client needs to do this himself with the help of accounting and other service providers.
Investor-level accounting is complex
Hedge fund accounting is much more complex than general ledger accounting. It layers in investor-level accounting, which means you have to take the general ledger cake out of the accounting oven each time an investor adds or takes out capital, carving up the pieces of the pie at that accounting-event juncture.
Get used to checklists for success
Here are some checklists we prepared:
1. Advance planning:
a. Meet with auditor to discuss:
i. New developments in the funds being audited (and any related entities)
ii. Changes in management or structure of organization
iii. New relationships (prime broker, attorney, administrator, etc.)
iv. Performance and change in net assets during the year
v. Significant or unusual transactions during the year
vi. Securities that may be difficult to price
vii. New Generally Accepted Accounting Principles (GAAP) requirements
viii. Investment advisor registration status and regulatory examinations during the year
ix. Filing deadlines and other client deadlines, such as K-1s and tax return
x. Services to be performed by CPA firm (auditor)
xi. Fees for audit
xii. Logistics
xiii. Timeline for completion of work and having the information available and organized for the audit
xiv. Administrator responsibilities with regard to audit, if applicable
xv. All documents in electronic format and use of an electronic and secure file sharing system
xvi. Trying to stay within the scope of planned audit procedures, focusing on risk
xvii. Utilize templates from auditor and learn how to us them
xviii. Have accounting data in summarized formal accounting software
xix. Avoid multiple changes and reviews to streamline the process
b. Auditor should also conduct planning meeting with fund administrator, if applicable, to discuss timing (i.e. schedule the audit, availability of report on internal controls, etc., and have all client-created work papers completed before the audit begins)
2. Auditor should perform the following as early as possible (ideally before year-end):
a. Risk assessment
i. Obtain or update understanding of the entity and its environment, including internal controls
ii. Obtain or update understanding of significant transaction cycles, including processes and controls
1. Perform virtual walk-throughs
iii. Fraud risk assessment
iv. Preliminary analytics and interim testing
b. Review fund documents (e.g., Limited Partnership Agreement, Offering Memorandum)
3. Interim procedures that can be done in advance:
a. Testing economic allocations
b. Review interim financial statements and portfolio
c. Journal entry testing
d. Broker statement testing
4. Prepare pro forma draft of financials, including footnotes
5. Timely response to auditor’s request for information for the audit
6. Audit confirmations prepared and ready to send out before year-end in electronic format.
Audit Pitfalls
1. Lack of a competent internal accountant and/or administrator.
2. Lack Poor of internal controls. .
3. Not understanding the role of the auditor vs. the administrator vs. the client.
4. Insufficient advanced planning.
5. Interim work not performed in advance.
6. Audit surprises cause delays. Examples are:
a. Client not informing the auditor in advance of significant issues that may affect the nature and timing of audit procedures (e.g., pending litigation).
b. Difficult to price securities or securities not custodied with broker that auditor was not informed of.
c. Fee waivers, side letters and related party transactions not previously discussed.
7. Delays in receiving items on the PBC (prepared by client) list. This entire list should be provided before audit field work begins.
8. Draft financial statements not prepared until end of audit.
Bottom line
In 2012, if you launched and operate a smaller hedge fund in short-term trading of marketable securities, futures or forex our area of expertise and are considering a new assurance (audit) and tax-compliance service provider, consider our CPA firm Green NFH, LLC. We can probably perform a stub-period audit for 2013 including the 2012 period and handle tax compliance for 2012 and 2013, too. It’s best to choose another assurance service provider if you have hard-to-value private securities or derivatives.
Our affiliated companies GreenTraderFunds.com and GreenTraderTax.com have been respected brand names in the active trading and hedge fund entrepreneur marketplace since 1997. Robert A. Green, CPA has worked with hedge fund clients on tax compliance since founding Green & Company CPAs in 1983.
Give your investors’ the confidence and assurance they seek by choosing Green NFH, LLC for your audit report and signed income tax returns.
Before we take on new audit clients, we make sure to get to know them. Many of our clients have used our tax services before they launch their hedge fund using an outside attorney, and they chose us for their audit and tax provider.
Trust, hard work, dedication, experience, ideas, passion for success and knowledge are the hallmarks of our company and CPA and tax attorney professionals.
Posted in: Hedge Funds, Trading Ideas, General