Hedge-fund investors depend on “assurance” from CPA firms

November 6, 2013 | 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. CPAs refer to an audit practice as an assurance service. Assurance is what hedge fund investors are looking for but an audit certainly doesn’t assure everything.

Investors fear fraud
Investors have a reason to fear fraud: There’s been plenty of it in the investment management industry including insider trading at SAC Capital Advisors, Ponzi schemes like that of Bernie Madoff, fake financial statements and deception in Bayou Hedge Fund Group, and smaller schemes, as well. In 2002, the AICPA’s Auditing Standards Board raised the bar on the auditor’s responsibility with SAS No. 99: Consideration of Fraud in a Financial Statement Audit.

It’s important to understand what an audit is, its limitations and what the audit report speaks to. The audit certainly does not guarantee to catch-all or any fraud and the auditor is not the one making representations and disclosures — management is. The auditor’s job is to express an opinion on the financial statements based on the 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 PFGBest 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. (Audit confirmations are now often processed electronically, fixing that glaring problem in the PFGBest audit.)

Advertising requires audited performance records
President Obama’s Jumpstart Our Business Startups Act (JOBS) lifts the advertising restrictions on certain private companies, including private hedge funds and private equity funds. The SEC adopted changes to Rule 506 of Regulation D in July 2013. The new rule, 506(c) became effective Sept. 23, 2013 and permits general advertising or general solicitation by issuers of private funds, such as hedge funds, with certain restrictions. You can imagine the floodgates opening over the Internet for investment managers advertising their audited performance records. For the first time, private hedge funds are able to advertise like mutual funds, opening up the marketplace to new investors. With advertising of performance records, audit reports from quality CPA firms become even more important than ever before. While investors may not be knowledgeable about the investment manager, they may know and trust the audit firm, as well as the fund’s other service providers.

Smaller funds should choose audit firms that best suit their needs
When it comes to choosing an audit firm, bigger doesn’t necessarily mean better. Small- and medium-sized hedge funds can be better served by small- or medium-sized audit firms that provide more individualized service and charge lower fees. Many of the well-publicized undetected frauds of the last decade were perpetrated by large hedge funds audited by big-four audit firms. Conversely, 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. Don’t confuse our incubator fund strategy –forming an investment vehicle that holds only proprietary (the owner’s) capital and does not offer interests to investors — with others who refer to incubator funds housed inside a successful hedge fund group or offices and infrastructure. The purpose of our incubator fund strategy is to generate a historical performance record for the Investment Manager. We use the term “incubator fund” to refer to a start-up hedge fund. An incubator fund is generally structured as a limited partnership (LP) or limited liability company (LLC). Since interests in the fund are not offered to outside investors, the Investment Manager does not charge management or performance fees. Accordingly, the LP agreement or LLC operating agreement excludes compensation and related clauses generally found in the operating agreements of hedge funds. For about one-half the initial legal fees to establish a hedge fund, 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 generally requires less audit testing, which means it also costs less than an audit of a fund that charges fees and has outside investors.

Choose your auditor early on
Sometimes an investment manager needs to list the fund’s auditor in a private placement memorandum or in registration forms; therefore you may want to choose your auditor early on.

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.

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 December 31, for a fund that started on October 1, 2012, it may be too costly to have an audit for the three-month period (the stub period) ending December 31, 2012. The investment manager may consider a 15-month audit for the period ending December 31, 2013. 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.

Another option is to start your audit period later
In the previous example, instead of including the 2012 stub period, the auditor can discuss the option of starting the audit period on Jan. 1, 2013. In this case, the auditor will audit the balance sheet as of Dec. 31, 2012 and use this as the starting point. If you formed a hedge fund in late 2011, this approach may make more sense.

Tax compliance services can’t be deferred
Many startup hedge funds may defer audits until managers feel they can raise meaningful money from investors, providing their LLC or LP agreement allows for that. While audits may be deferred, tax compliance may not be — the tax man is not patient. (Green NFH, LLC offers federal and state tax compliance services and is executing engagement letters now for tax compliance services for 2013.)

Performance record examinations are different from audits of financial statements
Hedge fund private placement memorandums (PPM) and LLC Operating Agreements often call for annual audited financial statements. But, managers also often want to distribute and advertise performance records which have been examined by a CPA firm. These are different from annual audited financial statements.

While CPAs adhere to GAAS in the U.S. for audits of financial statements, examinations of performance records are based on different attestation standards.

When are audited financial statements required by regulators vs. self-imposed?
SEC-registered (larger) investment advisers operating private investment 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 Public Company Accounting Oversight Board (PCAOB)-registered auditors. 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 alternative investment funds and managers. Audit work is dictated by GAAS and industry guides like the AICPA Audit Guide of Investment 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 quality. Hedge fund audits are often due within 120 days of year-end and auditors are on a strict time schedule. Investors want IRS 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. (WA performs audit services and Green NFH, LLC performs tax compliance services seamlessly.)

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 WA and Green NFH in November or December if you haven’t yet. January may be too late.) Just email us at hedgefunds@greencompany.com to get started with any of these services. We will follow-up immediately as time is of the essence.

Use a qualified accounting firm for monthly accounting
Many small hedge funds use an outside independent accountant for monthly net asset value (NAV) 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. Increasingly, investors want independent accounting — not accounting done by the investment manager. Internal controls are key, but if the manager does everything including the accounting, that’s not proper internal controls.

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; 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 financial reporting and accounting systems are auditable in an efficient and effective manner. That involves implementing proper internal controls and systems. Plan to use a respected outside accounting firm that specializes in hedge fund accounting and a separate CPA firm to conduct the fund’s annual audit. The fund will also need a 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 can be complex and requires more than preparing general ledger accounting entries. Partnership accounting requires that partnership gains and losses are allocated to the partners in each accounting period, usually based on each partner’s beginning of period capital balance as a percentage of total partners’ capital.

Get used to planning for success
Here are some planning items:
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

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
iib Perform 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. Poor internal controls.

3. Not understanding the role of the auditor vs. the administrator vs. the client.

4. Insufficient advance 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.