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Q1 2020 - Are You Ready for Your Annual Audit?

Feb 24, 2020

It’s that time of the year again.  There are some best practices to follow to avoid pitfalls and issues while preparing for and undergoing your year-end audit.  Implementing these best practices will enhance the value your organization receives from the audit process and will help you to comfortably meet your deadline for distributing audited financial statements to your investors. 


It is management’s responsibility to prepare financial statements and to design, implement and maintain internal controls relevant to the preparation and fair presentation of financial statements.  Management’s first step is to have an in-house accounting team who are capable of achieving effective financial reporting which enables management to prepare financial statements that are fairly presented.  While management can alternatively outsource the accounting function to a third-party service provider (for example, an external fund administrator) who can assist with preparation of the financial statements, it is important to keep in mind that management retains responsibility for the financial statements.   


If you haven’t already set up a planning meeting with your auditor, set it up now to discuss and provide an update to your auditor about what has occurred during the year.  Matters of interest to your auditor will include amendments to the partnership agreement and other fund documents, capital activity, fund performance, any new or difficult-to-value investments, and any other notable changes that occurred during the year.  Expected timing of audit fieldwork and audit completion should also be discussed at the audit planning meeting. If you have outsourced your accounting function to an external fund administrator, ensure that the expected timing fits into their schedule.

Ask your auditors if they are aware of any new accounting pronouncements that are applicable to you that you should be considering while preparing your annual financial statements. For example, Accounting Standards Update (ASU) 2016-18, Statement of Cash Flows (Topic 230) - Restricted Cash is effective for calendar year non-public entities as of January 1, 2019. ASU 2016-18 requires the statement of cash flows to explain the change during the period in the total cash, cash equivalents and amounts generally described as restricted cash or restricted cash equivalents. Amounts generally described as restricted cash or restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning of the period and end of the period total amounts shown on the statement of cash flows.

In addition, you may have heard about the new revenue recognition standard (known as Topic 606), which became effective for calendar year non-public entities on January 1, 2019. Topic 606 outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most previous revenue recognition guidance. While Topic 606 does not apply to financial instruments, and will therefore have little or no applicability to most private investment funds, asset managers providing investment management or advisory services should be aware of Topic 606 because it does apply to revenue such as management and advisory fee income, including incentive-based income.

ASK FOR THE AUDITOR’S YEAR-END REQUEST LIST (also known as the Prepared by Client [“PBC”] List)

It is a standard practice for auditors to provide their clients with a list of items they will need to get the audit rolling. Ask your auditor to provide this list well in advance of your fiscal year-end. Knowing ahead of time about some of the schedules and documents your auditors are going to need will help you keep these items in mind when you are going through the process of your year-end close. Share the list with your external fund administrator and agree on the expected timing of any audit schedules that they can help prepare. Carefully consider each of the schedules you may be preparing for the auditors. If any of them are considerably time consuming for you or your external fund administrator to prepare, ask the auditors to explain why they need them. It is possible that they could get the same information from another resource.

For continuing or repeat audits, it is worth saving copies of the current year schedules and documents you’ve submitted to your auditor for future reference. Make a note of the source within your accounting system, and the methods you have used, to extract specific customized reports that were part of the auditor’s current year request list. In absence of significant changes in your business or operations, your auditor will most likely request those specific customized reports on an annual basis. Revisiting your notes from the prior year audit will reduce your efforts in extracting those reports in the current year. This step is particularly helpful if you have had turnover in your accounting department and a new employee has taken over the responsibility of preparing and submitting information to your auditors.     


Before providing any of the requested schedules, documents, or backup to your auditor, check to make sure that the information agrees with your trial balance and/or internally prepared financial statements.  As an example, if you provide a schedule of partner contributions and withdrawals that does not reconcile to the corresponding amounts recorded in your trial balance, you will have opened up a whole can of worms. Even if you ultimately end up providing a corrected schedule that agrees to the trial balance, your auditors would want to know what changed and the reasons for the mismatch.  Any errors and/or reconciliations during the audit process add to the cost of the audit. Reviewing the audit schedules in advance can save you time during the audit and helps everyone focus on more important issues.    


The audit schedules that you submit to your auditors provide a good data point for them to begin their audit.  The auditors will have additional questions and most likely need to talk to you and/or your external fund administrator throughout the audit process.  Designating an individual to handle all audit-related requests and provide timely responses to all their questions will ensure an efficient audit.  A weekly or a bi-weekly audit status meeting between management and auditors provides touch points to discuss progress and resolve any issues identified during the audit.  


It is standard procedure for auditors to request confirmations from banks on account balances on all significant cash accounts. Other audit areas involving the confirmation process include investments and cash held at a qualified custodian; private investments, whether or not held at a qualified custodian; and capital activity including contributions, withdrawals and transfers of interests.  Auditors are required to transmit the confirmation requests themselves directly to the bank, custodian or investor and, in turn, the auditors must receive the confirmation reply directly from those parties in order for it to be valid.  When inaccurate balances or incorrect information are provided on the audit confirmation, someone has to spend the time following up to get corrected information.  The best chance at improving the accuracy of your confirmations is to prepare them as close to the confirmation date as possible.  So if your auditor needs a confirmation as of December 31, make sure that you have either signed any paper confirmations, or given electronic approval before this date.  The approved confirmation requests need to go out in the first week of January or as close to the year-end as possible. 


Auditors are required to include some element of “surprise” in their audit, so they are unable to tell you in advance absolutely everything that they plan to test. However, you can ask if there are any tests or testing selections that can be done ahead of time. Most accounting firms perform interim work covering transactions occurring in the first three quarters of the year. Purchase and sale of investments, realized gains and losses on sale of investments and capital activity are the most common audit areas that get covered during interim.  Interim procedures are the best way to avoid surprises at year-end as they provide your independent auditor an opportunity to look at your accounting records and provide recommendations way before the chaos of year-end hits you.  


Valuation of hard-to-value investments is of critical importance to investors and is often an area that is closely looked at by auditors and their valuation specialists. Your valuation policies and procedures should establish methodologies for various classes of investments, address effective alleviation of potential conflicts of interests, and provide for appropriate disclosures. You should also consider including qualified valuation professionals on your team who can contribute to implementation of your valuation policies and procedures.  Most auditors will expect that the management will prepare a comprehensive year-end valuation package for all hard-to-value assets they hold. The valuation package should provide a comprehensive write-up for each private investment being valued, including references to applicable support and documentation included within the valuation package. Clearly explain within the valuation package your rationale for any specific factors such as discounts due to lack of marketability or lack of control inputs. Providing substantial rationale for any changes in valuation methodology or inputs that have changed from prior valuation periods helps avoid follow up questions from your auditors. 

In August 2019, the American Institute of Certified Public Accountants (AICPA) issued guidance for investment companies on how to fair value their portfolio company investments. The accounting and valuation guide is titled Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies and is intended to harmonize views of industry participants, auditors and valuation specialists. The goal of the guide is to provide user-friendly guidance with case studies that can be used to reason through real-life situations faced by fund managers. The newly issued valuation guide is a helpful resource that can be utilized by the fund managers preparing their year-end valuation packages.


Encourage the use of technology and request access to all the available tools/solutions that your auditor’s firm offers. Audit firms across the globe invest significantly in technology and solutions that make life easier and work more productive. Some of the common technology solutions offered by audit firms to their clients include use of secure file sharing portals/erooms and use of electronic signature technology services such as DocuSign. Utilizing all the available technology solutions can significantly enhance efficiency, aid compliance with applicable data protection rules and add value to the audit process. 


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Vikram Deshpande

Vikram Desphande provides a range of services including audits of hedge funds, private equity funds and venture capital funds.

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