The world is changing every single day, so auditors also have to change the way they attack auditing alternative investments. New alternative investments continue to emerge, with each investment manager having a unique strategy to produce returns during both rising and falling markets.
Alternative investments by definition are not your traditional stocks, bonds, or mutual funds. They are not publicly traded, and their underlying assets can include complex and/or illiquid investments. There are several types of alternative investments, all with different investment strategies, liquidity, and risks. They include some of the following:
Alternative investments pose a great deal of risk to auditors. Due to the increase in the number of options and the fact that alternative investments can potentially produce greater returns, more plans are allocating a larger percentage of assets to alternative investments. As a result, auditors are facing greater risk of the financial statements being materially misstated.
Another risk auditors are facing is the lag in reporting between the custodian/investment manager’s statement date and the actual date the alternative investment was valued. For example, a custodian’s statement dated December 31, 2016, may be showing the value of the investment as of September 30, 2016.
According to the American Institute of Certified Public Accountants, the steps to auditing investments are to identify risks (how risky is the investment portfolio?), assess the risk, and design procedures to reduce risk. The most difficult of these steps is designing the procedures and, even more importantly, gathering enough adequate audit evidence.
Before the start of an audit, the auditor should have already been in communication with plan management, discussing their investment portfolio and any new alternative investments. At this stage, an auditor requests and reviews all new or updated investment agreements. Information located in these agreements can provide valuable insight on what type of investment the plan has invested in, their proposed commitment, withdrawal restrictions, and any additional capital commitments. Additionally, before the start of any audit, an auditor should gain an understanding of how the plan is recording the value of the investment. Are they utilizing a custodian statement? Are they comparing custodian values to each investment manager statement? And, are they reconciling their recorded values to values reported on investment consultant reports?
The next step is for auditors to reach out to the custodian, consultant, and each investment manager for independent confirmations. However, confirmations alone do not constitute adequate audit evidence. Since alternative investments are considered a significant risk area, auditors need to perform extended audit procedures.
The type of alternative procedures auditors perform will vary depending on the type of investment and the information they are able to obtain. One of the best types of documentation an auditor can obtain is independently audited financial statements, using generally accepted accounting principles (GAAP), from a large well-known accounting firm, with an unmodified opinion. Compare net asset value contained in the financial statements to the net asset value reported by the investment manager and understand the adjustments that were made or will need to be made to net asset values, if any, to arrive at fair values. It is important that those audited financial statements are the same year-end as the plan’s financial statements and that the assets are valued at fair value. For example, if the plan is invested in a common collective trust (CCT) with audited financial statements as of a date that is three months prior to its year-end, the auditor needs to determine how the value of that CCT may have changed over the three-month period between the date of the CCT’s financial statements and the date of the plan’s financial statements. Utilizing benchmark and expected returns based on publicly available data is useful here.
In cases where audited financial statements are not available or are not prepared on the GAAP basis, the auditor will have to spend additional time gathering adequate audit evidence. Consider using publicly filed (audited) quarterly 10-Q or 10-K reports. If invested in real estate, communicate with the investment manager and determine the most recent independent appraisal that was performed. Gather the appraisals and compare to values reported for the plan’s real estate holdings.
Communication is key to auditing alternative investments. Collecting as much information about these hard-to-value investments, whether from the investment manager or the plan’s investment consultant, will help the auditor devise the best approach possible to gain adequate audit evidence to substantiate the value of these investments at the plan’s year-end.
By Michael Tiberi, CPA, CFE, Manager, mtiberi@legacycpas.com