Family Office Audits: Entity Structure, ASC 946 Assessment and Valuation of Private Holdings

A family office is rarely one entity. It is a management company, several investment partnerships or LLCs, trusts, operating businesses, real estate holding companies, and sometimes an aircraft, a collection of art or a foundation, all tied together by common family ownership. The first job on the engagement is to decide which entities the financial statements cover and which framework governs each.

The second job is to value what is inside them, much of which has no market price.

Define the reporting entity first

Family offices ask for audits for lenders, for trustees, for family governance and sometimes for co-investors. Pin down early:

• Which entities are in the statements. One investment vehicle, the management company, a combined group, or a consolidated family structure.
• Who the users are. A bank reading a pledged-asset report needs different information than a family council.
• The basis of accounting. US GAAP, or a special purpose framework under AU-C 800 such as tax basis or a contractual basis.
• Common control. Entities under common family ownership are related parties of each other, and combined statements need a stated basis of combination.

Build an entity chart showing ownership percentages, general partners, trustees, bank accounts and which entity holds each asset. Most misstatements in these engagements start with an asset recorded in the wrong entity.

Is the entity an investment company under ASC 946?

If a vehicle qualifies as an investment company, it reports investments at fair value and follows the specialized guidance in ASC 946. If it does not, ordinary GAAP applies: consolidation of controlled entities, the equity method for significant influence and cost-based or ASC 321 measurement for the rest.

ASC 946-10-15-6 sets two fundamental characteristics:

1. The entity obtains funds from one or more investors and provides them with investment management services, and commits to its investors that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both.
2. The entity or its affiliates do not obtain, or have the objective of obtaining, returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests or that are other than capital appreciation or investment income.

Paragraph 946-10-15-7 adds typical characteristics: more than one investment, more than one investor, investors that are not related parties of the parent or the investment manager, ownership interests in the form of equity or partnership interests, and management of substantially all investments on a fair value basis. Under paragraph 15-8, an entity must possess the fundamental characteristics, and the absence of one or more typical characteristics does not necessarily preclude investment company status, but the entity must apply judgment about how its activities remain consistent with those of an investment company.

Family offices test these in a specific way. A vehicle owned entirely by one family has no unrelated investors, which is one of the typical characteristics it lacks. Judgment is required, and the second fundamental characteristic is where many conclusions turn: if the family office or its affiliates obtain benefits from an investee other than ownership returns, such as management fees from a company the family controls, shared services, or preferential purchasing terms, the entity is not an investment company.

When an entity is an investment company, an investment company generally does not consolidate an investee that is not an investment company. It measures controlling interests in noninvestment company investees at fair value (ASC 946-810-45-2). When it is not, the controlled operating business is consolidated and its results flow into the family office's statements. See the ASC 946 standards page and the investments guide.

Document the assessment entity by entity. A conclusion for the investment LLC does not carry to the management company that bills it.

The regulatory definition is a different test

The SEC's family office rule under the Investment Advisers Act, adopted in Release IA-3220, defines which offices are excluded from the definition of an investment adviser. It is not an accounting test, but it supplies useful facts. A family office must advise only family clients, and the rule defines family members as all lineal descendants of a common ancestor, with current and former spouses or spousal equivalents, provided the common ancestor is no more than 10 generations removed from the youngest generation of family members. Family clients also include certain key employees, charities funded exclusively by family clients, estates, trusts existing for the sole current benefit of family clients, and companies wholly owned exclusively by, and operated for the sole benefit of, family clients. The facts that define family clients, who owns the vehicle and who it serves, are the same facts you need for the ASC 946 assessment and the related party analysis.

Valuation of private holdings

Most of the audit effort goes to investments that do not trade.

• Private equity and hedge fund interests. Obtain the most recent capital account statements and audited fund financial statements. Reconcile the reported net asset value to the statement date and roll it forward for contributions, distributions and the period between the fund's reporting date and the balance sheet date. Where the NAV practical expedient is used, document that the criteria were met.
• Direct private company holdings. Evaluate the valuation method, the data and any specialist involvement. See ASC 820 and treat unobservable inputs as Level 3.
• Real estate. Appraisals, cap rates and debt. Confirm title and encumbrances.
• Collectibles and aircraft. Acquisition cost, insurance valuations, and whether they are held for investment or personal use by the family. Personal use items need a policy decision on whether they belong in the statements.

Obtain direct confirmations from custodians and fund administrators; an unconfirmed brokerage statement supplied by the family is not sufficient evidence.

Related parties and allocations

Almost everything is a related-party transaction. Loans to family members, shared payroll, expenses paid by one entity for another, and personal expenses run through the office all need testing under AU-C 550 and the related party transactions guide.

Management company allocations deserve a separate schedule. Example: a management company incurs $2,400,000 of annual costs and bills three family branches by assets under management of $60,000,000, $30,000,000 and $10,000,000. The allocation is 60%, 30% and 10%, or $1,440,000, $720,000 and $240,000. The test is whether the allocation basis matches the agreement, was applied consistently, and eliminates on combination.

Typical audit procedures

1. Obtain the entity chart, governing documents, trust agreements and operating agreements.
2. Prepare the ASC 946 assessment for each entity and a consolidation memo.
3. Confirm investments and cash with custodians, administrators and fund managers.
4. Test valuation of Level 3 holdings and NAV-based holdings.
5. Test capital activity: contributions, distributions, capital accounts and tax distributions.
6. Test related party transactions, loans and allocations; evaluate eliminations.
7. Evaluate completeness of entities, liabilities, guarantees and commitments, including unfunded capital commitments.
8. Review the tax structure for entity-level taxes and pass-through reporting.

PBC items

• Entity chart and legal documents for every entity in scope
• Custodian and brokerage statements, and fund capital account statements
• Audited financial statements of fund investments
• Valuation support for private holdings and real estate
• Capital account schedules, distribution records and tax distribution calculations
• Intercompany and related party schedules, loan agreements and allocation methodology
• Unfunded commitment schedule and guarantee list
• Prior year tax returns and K-1 packages

Red flags

• Assets held in entities not on the entity chart
• Personal expenses of family members paid through investment entities
• Related party loans with no documents
• No documented investment company assessment
• Fund investments valued from a manager's email, not a statement

Sources

• FASB ASC 946-10-15-6 through 15-9 and 946-810-45-2, text reproduced in PwC Viewpoint, FASB ASU 2013-08, Investment Companies
• SEC, Family Offices, Release No. IA-3220 (final rule, 17 CFR 275.202(a)(11)(G)-1)
• 17 CFR 275.202(a)(11)(G)-1, Family offices, Legal Information Institute: https://www.law.cornell.edu/cfr/text/17/275.202%28a%29%2811%29%28G%29-1
• SEC, Family Offices, Release No. IA-3098, proposing release, 75 Federal Register 63753
• FASB ASC 820, Fair Value Measurement; AICPA, AU-C Section 550, Related Parties

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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error