Alternative investments—that is, investments that do not have a readily determinable fair value—commonly found in not-for-profit portfolios are becoming more sophisticated in both structure and underlying investment types. Examples include private equity funds, real estate funds, real estate investment trusts (REITs), hedge funds, common collective trusts, pooled separate accounts, offshore investment funds, and real assets such as mineral rights and timber. These investments tend to be more complex, not as liquid, and typically contain various redemption restrictions—qualities that, for auditors, can mean a greater risk of misstatement and a need for more persuasive audit evidence. This article discusses some key considerations for auditing alternative investments.
Some alternative investments can be hard to identify, especially when investment custodian reports differ in the format and amount of information provided. In particular, for funds like pooled separate accounts and common collective trusts, the names of the funds can sound similar to mutual funds or exchange-traded funds. Fair value testing over a sample of investments can help auditors identify investments that are not traded on an active exchange that provides public quotes. Additionally, the following procedures can be performed to identify potential alternative investments:
- Perform inquiries with the not-for-profit or the not-for profit’s investment consultant if they have any alternative investments or investments that do not have a readily determinable fair value.
- Perform inquiries with the financial institution regarding any investments listed on the investment statements for which they do not actually serve as custodian. Some investment statements will identify those investments with a specific mark such as an asterisk.
- Review the investment statements for unique portfolio titles such as “miscellaneous,” “other,” or “alternative strategies,” which may indicate that those investments are actually alternative investments.
- Perform an Internet search of the investment. This will provide additional information and insight to determine if the investment is actually an alternative investment.
2. Accounting Basis
Many not-for-profit organizations now invest in international companies whose accounting basis may not be U.S. GAAP. Instead, these companies may be following International Financial Reporting Standards (IFRS). Not-for-profits also invest in other complex investment vehicles, such as start-up companies or residential home loans, that may use another accounting basis such as tax or cost. The investee’s basis of accounting (and the valuation techniques contained within it) may be relevant to the pricing of the investment and whether the practical expedient (net asset value) can be used. Technical Questions and Answers (Q&A) sections 2220.18–.28 may be useful. Any differences from U.S. GAAP and the measurement principles of FASB ASC 946 would need to be evaluated. If the differences are material, an adjustment would be necessary to ensure that the investments are reported at fair value. The nature of the adjustments would be included in the description of the valuation technique(s) and the inputs used.
3. Audit Approach
There is no one size fits all approach for testing alternative investments. Described below are just some of the various approaches auditors may consider using. In some cases, using more than one technique may be appropriate depending on the auditor’s risk assessment; significance of the alternative investments to the financial statements; the nature, complexity, and liquidity of the alternative investment; and the understanding of the not-for-profit’s controls and due diligence procedures.
Confirming key details of an alternative investment directly with the fund or investee company can provide audit evidence to support the existence assertion.
Understanding the valuation process and assumptions
Numerous techniques can be used to value an alternative investment—so many that they could fill a separate article. Reading prospectuses for the investments and holding inquiries with appropriate personnel at the financial institution or company, depending on the nature of the investment, can help auditors gain an understanding of the valuation process and assumptions. Reading the audited financial statements can also provide insight.
Most alternative investment funds are audited on an annual basis and typically have a December 31st year end. These audited financial statements should be obtained and reviewed to determine the basis of accounting used. They should also be reviewed to determine if the auditing firm that performed the audit has the expertise to perform these types of audits.
The not-for-profit entity’s ownership percentage in the alternative investment fund should also be obtained from the fund manager directly, which can be accomplished during the confirmation process. If the not-for-profit has the same year end as the alternative investment fund, the not-for-profit’s ownership percentage could be applied to the audited equity amount of the fund to estimate the value of the not-for-profit’s share of the fund as of the year end. This should be compared to the value that the not-for-profit recorded on their financial statements for material differences. If the not-for-profit does not have the same year end as the alternative investment fund, the same procedures would be applied as noted above; however, an investment benchmark related to the fund would need to be identified to predict the investment value as of the not-for-profit’s year end. The predicted value would be compared to the value that the not-for-profit recorded on their financial statements for material differences.
Testing transactions near the statement of financial position date
Testing purchases or sales at or near the statement of financial position date can provide evidence of a third-party market (and thus fair value). Many times, the investee or investment custodian will provide this information upon request.
Auditing alternative investments can sound like a daunting task but with an appropriate game plan, it doesn’t have to be. Keep these considerations in mind the next time you come across an alternative investment in a not-for-profit audit.
Not-for-Profit Section members can download, or purchase at a discount, the following additional resources related to auditing alternative investments:
- Auditing Alternative Investments (downloadable PDF)
- Alternative Investments (downloadable work paper template in Excel)
- Not-for-Profit Entities - Audit and Accounting Guide (see Chapter 4 Appendix A – Determining Fair Value of Alternative Investments) – The Guide is available in the AICPA Store in online, eBook, and paperback formats; NFP Section members receive a 20% discount.