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AUDIT A complex crunch Hedge <strong>fund</strong>s’ edge is auditors’ challenge, the BVI’s audit commuity tells Phyllis Feinberg, as they explain what constitutes best practice amid new instruments and accounting standards that face them every day “In an ideal world all the investments that a <strong>fund</strong> holds would have a quoted market price,” says Mark Chapman, partner at Deloitte. “As products become more complex today it is sometimes not straightforward to obtain the fair market value for investments.” Valuing securities to get <strong>hedge</strong> <strong>fund</strong>s ready for their audits is sometimes difficult as their investment products become more and more complicated.” “A lot of background comes from the broker’s statement,” says Kay Reddy, managing director of Blenheim Fund Services (BVI). “When a discrepancy arises in valuing a <strong>fund</strong>’s assets we have to take extra steps.” She adds that some administrators prepare general ledgers from brokers’ statements. “I think that’s flawed,” she says. “We want to account for each transaction unless it is a <strong>fund</strong> of <strong>fund</strong>s,” she adds. “We do make sure the numbers are correct—it’s important to have someone who’s knowledgeable to give advice to (a <strong>fund</strong>’s) key people.” Hedge <strong>fund</strong>s are investing in more “exotic” products, according to Peter O’Connell, managing director at Conifer. “Our challenge is coming up with ways to value the securities. We may use a specialist independent valuation agent. We’ve done it for a real estate <strong>fund</strong>. It presents real challenges.” Valuing securities to prepare financial statements and get a <strong>hedge</strong> <strong>fund</strong> ready for audit “involves extra preparation and we charge extra for it,” says O’Connell. “Only the biggest clients have the ability to do it in-house.” Clayton Burton of Fortis Prime Fund Solutions says, “we download information from the prime broker and use industry specialists to help value harder stocks.” He points out that investments in <strong>hedge</strong> <strong>fund</strong>s “are sometimes quite different from those in other markets.” Since an auditor can’t audit a <strong>fund</strong> for which it’s provided the valuation of the securities, “we rely on valuations from market makers,” says Ryan Geluk of BDO Binder. Geluk says he would go to BDO’s pricing department in New York, for a difficult valuation. “We request information and look at the reputation,” of the firm providing the valuations, he adds. Deloitte’s Chapman says that “we look at fair value on a case by case basis. Where we can’t immediately find a fair market value for the investments, we make sure the <strong>fund</strong> has used every available source.” He points out that, “at Deloitte we have the resources to confirm the value of even the most complex securities.” “We rely on professional thirdparty pricing sources to value the securities,” says Nigel MacPhail, partner at Baker Tilly. He says that the complexity of the investments in the <strong>fund</strong> affects how difficult it is to determine the portfolio value of a <strong>fund</strong>. He adds that the amount charged for an audit is determined “on a case by case basis,” depending on the difficulty and size of the <strong>fund</strong>. Chapman says that there have been no significant changes in audit requirements in Europe and the United States, although “there is a move to have <strong>fund</strong>s audited under international standards.” However, he also says “the accounting profession regularly brings out new pronouncements. Moreover, “whatever impacts <strong>hedge</strong> <strong>fund</strong>s worldwide affects British Virgin Islands <strong>fund</strong>s — we apply exactly the same principles in terms of accounting and auditing practices as are applied in the rest of the world,” he says. When a <strong>fund</strong> uses US GAAP accounting or International Financial Reporting Standards, “any change affecting the <strong>fund</strong> will impact the audit,” he adds. “At the end of the day, in general a <strong>hedge</strong> <strong>fund</strong> is relatively straightforward to audit,” according to Chapman. An auditor looks at the <strong>hedge</strong> <strong>fund</strong>’s investments and the fair values of them. “If the <strong>fund</strong> uses US GAAP, there’s more disclosure required than if it uses IFRS—under US GAAP <strong>fund</strong>s have to disclose the names of significant security positions.” Chapman says that a <strong>hedge</strong> <strong>fund</strong> has to decide which auditing rules it will use. “Most <strong>fund</strong>s use International Financial Reporting Standards or US GAAP accounting,” says Tanis Tanis McDonald, KPMG Mark Chapman, Deloitte Nigel MacPhail, Baker Tilly McDonald, senior manager, KPMG. “We have to follow any changes that are made to the standards.” She adds that KPMG “has the depth of experience globally to handle any potential future changes in standards.” A new rule by the FASB—FAS Statement 157 Fair Value Measurements — is effective for financial years beginning after 15 November 2007. <strong>The</strong> statement establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and requires additional disclosures about the assumptions used to determine fair value measurements. “It will have an effect on those <strong>hedge</strong> <strong>fund</strong> investments that are already difficult to value, by requiring that it provide additional disclosures about the fair value of the investment,” says McDonald. She says that additional disclosures about fair value measurements require that investments are classified in a fair value hierarchy in which there are three levels. <strong>The</strong> fair value hierarchy refers to the relative reliability of inputs to a valuation technique used in arriving at a fair-value estimate. <strong>The</strong> first level, according to McDonald, are investments “that will have a quoted price in an active market for identical instruments, such as stocks listed on a stock exchange.” Level two — a step up in difficulty — “might be a security with an observable price in an active market for similar instruments or prices for identical or similar instruments in markets that are not active,” says McDonald. However, besides stocks and bonds, this level may include securities, such as over the counter derivatives; exchangetraded derivatives or possibly an interest rate swap based on Libor. “Libor would be the observable input if available at commonly quoted intervals for the full term of the swap,” says McDonald. “<strong>The</strong> assumption here is that there are no quoted market prices for these instruments, but only calculated fair value based on market inputs such as yield curves.” Level three investments are the most difficult for which to determine a fair value, according to McDonald. She says, a good example of such a security would be a derivative instrument, such as Zimbabwe dollar/Malawi Kwacha 30-year currency swap. “<strong>The</strong>re are no observable FX rates because it’s long-dated it cannot be corroborated by observable market data at commonly quoted intervals or otherwise for substantially the full term of the swap,” she explains. “When you prepare the financial statements you have to determine where the investments fit in this hierarchy,” KPMG’s McDonald says. “<strong>The</strong> grayest area is between levels two and three.” Moreover, she points out, “because <strong>hedge</strong> <strong>fund</strong>s have not applied the standard there isn’t a basis to guide you as to which level the instrument might fall into. It’s important for <strong>hedge</strong> <strong>fund</strong>s and investment companies to liaise with their auditors and have discussions about this early on.” However, she points out, “the new disclosures required by FAS 157 are not particularly complicated. It’s information that should be at hand from the investment manager, in which they will be required to provide input as to the classification of investments held at each level based on the valuation techniques and inputs used. “What could be controversial is that the disclosures will make the level of risk more transparent to the users of the financial statements. Investors and potential investors are likely to be particularly interested in the amount and type of level three classified investments.” Problems come when a <strong>fund</strong> may have financial problems and an auditor in good conscience cannot sign off the audit. Chapman notes: “Sometimes a <strong>fund</strong> auditor will choose to resign for any number of reasons and <strong>fund</strong> managers need to be aware of the impact on shareholder perception if an auditor resigns.” <strong>The</strong> issue of a <strong>hedge</strong> <strong>fund</strong> having its fiscal year end on a date other than 31 December is also under discussion for some <strong>fund</strong>s. “If a <strong>fund</strong> does its audit in June and not December, the audit fees may well be less,” says Chapman. However, he says “most US <strong>fund</strong>s have a December yearend, but using the calendar tax year is often not an issue for European and Far East <strong>fund</strong>s.” He also points out that for <strong>fund</strong>s of <strong>hedge</strong> <strong>fund</strong>s— which usually wait for the audits of the <strong>hedge</strong> <strong>fund</strong>s in which they are invested before doing their own audit—the 31 December date is often a pre-requisite. At KPMG McDonald says, “we’ve suggested it (<strong>fund</strong>s changing from the traditional year-end) and said we may be more accommodating if they move their year-end.” She says that by moving the timing of an audit out of the traditional busy season, the audit can be completed more efficiently. A more efficienct audit can result in cost savings that could be passed onto the client. MacPhail says that, “it would be lovely if a <strong>fund</strong> could use a year end other than 31 December and if we could spread the work out.” However he says Baker Tilly would be amenable to a lower fee. “Globally there is a shortage of good quality accountants,” says Tanis McDonald. “Salaries have been the biggest hurdle, a problem which has been exaccerbated by the recent weakening of the dollar,” she adds. S8 | BRITISH VIRGIN ISLANDS SUPPLEMENT HEDGE FUNDS REVIEW | October 2007 www.<strong>hedge</strong><strong>fund</strong>sreview.com
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