A private fund audit looks nothing like an operating company audit. There is no revenue cycle and no inventory. The entire balance sheet is investments and capital, and the number every investor cares about is net asset value (NAV). The audit comes down to three questions: is the entity an investment company, are the investments at the right fair value, and did each investor receive the right allocation of the result.
This guide covers the accounting framework, the fund-specific statements, the procedures and the points where files go wrong.
Confirm that ASC 946 applies
An entity regulated under the Investment Company Act of 1940 is an investment company for financial reporting. Any other entity assesses the fundamental and typical characteristics in ASC 946-10-15-6 through 15-9.
The fundamental characteristics are that the entity obtains funds from investors and provides investment management services, commits to investors that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both, and does not obtain or have the objective of obtaining returns or benefits from an investee that are not normally attributable to ownership interests. The typical characteristics are 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. An entity must have the fundamental characteristics; missing a typical characteristic requires judgment but does not by itself preclude status.
Document the assessment and revisit it when the strategy changes. Funds that take board seats or receive fees from portfolio companies need the assessment revisited. See the ASC 946 standards page and fund accounting overview.
What the financial statements contain
Investment companies report financial position with a schedule of investments, results with a statement of operations and financial highlights, and changes in capital with a statement of changes in net assets.
- Schedule of investments. It is an integral part of financial position because of the significance of the portfolio. It can be presented on the face of a statement of net assets or as a separate schedule.
- Financial highlights. ASC 946-205 requires financial highlights, which cover per-share information, ratios to average net assets and investment returns.
- Statement of cash flows. ASC 230 exempts certain investment companies that meet its stated conditions. Test each condition against the ASC 230 text; the exemption is not automatic.
- Consolidation. 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).
- Master-feeder funds. The feeder's file needs the master fund's financial statements.
Valuation: the center of the audit
Most investments are measured at fair value under ASC 820. The audit approach depends on the hierarchy level.
- Level 1 and Level 2. Price independently with a pricing source and compare to custodian and administrator values. Evaluate stale prices and thinly traded positions.
- Level 3. Obtain management's valuation policy, pricing committee minutes and models. Test inputs against transaction evidence, evaluate calibration to the transaction price and consider an auditor's specialist. See AU-C 540 and the ASC 820 guide.
- Investments in other funds. Where the NAV per share practical expedient is applied, evaluate whether it is appropriate for that investee and obtain the investee's audited financial statements and capital statements. Roll forward from the investee's reporting date to the fund's reporting date. Disclosures under Topic 820 apply when the expedient is used.
Funds that close the books before final investee statements arrive use estimates; test them against the final statements received after year end.
Capital accounts and allocations
The partners' capital rollforward is the second major test area. For each investor, trace beginning capital, contributions, withdrawals and the allocation of income and expenses to the closing balance.
Performance fees are the highest-risk allocation. Fund documents define the fee base, the hurdle rate, loss carryforwards and crystallization. Loss carryforwards reduce future performance fees, and some governing documents defer the allocation of unrealized gains or carried interest until a later event. Read the documents to find which applies, and agree the calculation to them.
Worked example (illustrative numbers)
A fund begins the year with NAV of $50,000,000. During the year it receives $5,000,000 of subscriptions and pays $3,000,000 of redemptions. Gross investment gains, realized and unrealized, are $6,000,000. The management fee is 1% of beginning NAV, and other expenses are $200,000. The incentive allocation is 20% of net profit before the incentive, with no hurdle and no loss carryforward.
| Item | Amount |
|---|---|
| Gross investment gains | $6,000,000 |
| Management fee (1% x $50,000,000) | ($500,000) |
| Other expenses | ($200,000) |
| Net profit before incentive | $5,300,000 |
| Incentive allocation (20%) | ($1,060,000) |
| Net increase attributable to limited partners | $4,240,000 |
Ending NAV to limited partners = $50,000,000 + $5,000,000 - $3,000,000 + $4,240,000 = $56,240,000. The general partner's incentive allocation of $1,060,000 is reported in its capital account.
The test is to recompute the fee for every class or series, including timing of subscriptions and redemptions within the year. The administrator's investor-level report should agree to the fund's capital statement and to the financial highlights. Any difference between the two is a finding.
Typical audit procedures
- Evaluate and document the ASC 946 assessment.
- Obtain independent confirmations of investments, cash, derivatives and borrowings from custodians, prime brokers and counterparties.
- Test the existence and ownership of every investment, including private holdings and side pockets.
- Test valuation using independent pricing for Level 1 and 2 and specialist-assisted procedures for Level 3.
- Recompute management fees, performance fees and expense allocations from the governing documents.
- Agree investor capital activity to subscription documents, redemption notices and bank statements.
- Recompute financial highlights and agree them to the capital statement.
- Test cutoff on trade date, subscriptions and redemptions.
- Evaluate the administrator's controls and the reports the fund relies on. See AU-C 500 for information produced by the entity.
- Evaluate going concern, liquidity terms, gates and subsequent events.
PBC items
- Offering memorandum, partnership or operating agreement, and side letters
- Investment management agreement and fee calculations
- Custodian, prime broker and counterparty statements
- Administrator trial balance, NAV package and investor-level capital statements
- Trade blotter and realized gain schedule
- Valuation policy, pricing committee minutes and Level 3 valuation files
- Financial statements of underlying funds and capital statements
- Subscription and redemption documentation
- Schedule of unfunded commitments and related party transactions
- Prior year financial highlights calculations
Red flags
- Valuations that do not move when comparable market prices do
- Performance fee calculations done outside the administrator
- Redemptions paid at a NAV different from the reported NAV
- A large share of the portfolio at Level 3 with no independent valuation
- Side letters with preferential liquidity or fee terms that are not reflected in the allocations
- Custodian statements that differ from the books
- A change in administrator or valuation method shortly before year end
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
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures; AU-C Section 500, Audit Evidence
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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