United States

3 hot audit topics for investment companies in 2016

Key issues: Valuation disclosures, cash flow exemptions, independence


Following is an overview of three hot audit topics that will affect investment companies in 2016:

  1. ASU 2015-07, Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or its equivalent). Currently, fund of fund investments valued using the reported net asset value, or practical expedient method, are categorized in the fair value hierarchy based on liquidity, generally as either level 2 or level 3, depending on their redemption and lock-up provisions. Under ASU 2015-07, these investments are no longer required to be categorized in the fair value hierarchy. This change is effective Dec.15, 2016, but early adoption is permitted. Retrospective application is required, and all affected financial statements should be restated. Investment companies are not required to value investments using the NAV method, but all investments categorized as level 3 that are not valued using that method still require quantitative valuation disclosures. ASU 2015-07 does not affect other required disclosures for fund investments, such as investment strategy, liquidity, estimated life and remaining capital commitments.
  2. Statement of cash flows exemption under FASB ASC 230-10-15-4. Preparation of the statement of cash flows is often a challenge for investment companies. But many hedge funds and unregistered investment vehicles can avoid this challenge because they can qualify for an exemption under FASB ASC 230-10-15-4. This exemption is available for investment companies provided all of the following conditions are met:
    1. During the period, all of the entity's investments were highly liquid (e.g., marketable securities and other assets for which a market is readily available, typically shown as level 1 on the fair value hierarchy).
    2. Substantially all of the entity's investments are carried at fair value.
    3. The entity had little or no debt, based on average debt outstanding in relation to average total assets during the period. (Debt includes broker margin balances for a substantial portion of the year or any extension of credit by the seller that is not in accordance with standard industry practice for redeeming shares or settling purchases of investments. Obligations resulting from redemptions of shares by the entity or from unsettled purchases of securities or similar assets, or from covered options, generally may be excluded from average debt.).
    4. The entity provides a statement of changes in net assets.
  3. Auditor independence. Clients and auditors both need to take responsibility for ensuring auditor independence under SEC rules, which apply to funds that are managed by investment advisors that are registered with the SEC or a state regulator. Rule 2-01(c)(4)(i)(B) of SEC Regulation S-X prohibits an auditor of a client that is subject to SEC independence rules from preparing or substantially assisting in the preparation of the audit client's or its affiliate's financial statements. Prohibited auditor activities include typing, formatting and editing of client financials statements. Allowed activities include proofreading, providing guidance on formatting, and marking up client-prepared financial statements with suggested edits and comments. In 2014, the SEC sanctioned eight CPA firms that had prepared financial statements for brokerage firms for violating auditor independence rules. In 2015, the Public Company Accounting Oversight Board's Annual Report on the Interim Inspection Program Related to Audits of Broker Dealers found that 25 percent of audits selected for inspection had independence findings related to audit firms preparing or assisting in the preparation of financial statements. While these sanctions related to broker dealer audits, the same potential exists for any investment advisors and their related funds that are subject to SEC rules. Independence is not a trivial concern. Should a fund and its auditor run afoul of SEC independence rules, the SEC could require that the fund's financial statements be re-audited.

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