How fund managers can prepare for tax and audit season

Chase McWhorter, Institutional Real Estate, Inc.’s managing director, Americas, recently spoke with Dorota Kowalski, Senior Director, Fund Accounting with Juniper Square. Following is an excerpt of that conversation.

First, there is the auditor, who really drives the entire process. If the fund manager outsources their back office functions—all the accounting and reporting—then a third-party fund administrator will also be part of the ecosystem. As the official books and records keeper, the fund admin will provide the auditors with all the evidence and documentation they need to perform the audit. Sometimes the fund manager’s legal team will also get involved as needed.

To build a working ecosystem among these service providers, everyone must agree that we are on the same team. We’re here to support our mutual client, the fund manager. Everyone must also communicate frequently. Establishing regular meetings is important—not just during the audit season but throughout the year. Getting to know each other is also critical. Not just who is on each team and what they do, but also how they like to work. This helps minimize stress and streamlines information sharing during the hectic tax and audit season.

The number of check-ins between the auditor and the fund manager depends on the scope of the audit.

The audit starts with a kickoff call and a planning phase, which the auditors lead. At some point, there is a conversation with the fund administrator about the audit process and what the auditors will be looking for. During this stage, the parties decide on the timeline and the deliverables—what will be requested by the auditors, when it will be due, and in what type of format. There is this principle of not documented, not done that auditors follow. Auditors might ask during the planning phase, “Do you conduct cybersecurity exercises?” or “What is your policy around valuation?” This is so they can assess the control environment, which is ultimately used to determine the risk and scope of testing. The fund manager may be able to describe what controls, policies, and procedures they use to conduct their business, but if they don't have that information documented anywhere, auditors will have an issue with that.

Once the planning phase is done, auditors start the fieldwork. Typically right before that, they establish another call and let the administrator know what the game plan is in terms of timing and the audit areas they will be focusing on. The audit process generally starts when the fund admin sends the entire population of transactions that took place during the period under audit. From that, the auditors select activities they will test—“Here are the audit samples that we need you to provide, along with any evidence or documentation to support what you’ve recorded and reported to the investors.”

With funds, where you have many transactions throughout the year, there's a lot of documentation that needs to be provided. Auditors require evidence that a transaction took place, that it was properly valued, and that it was ultimately reported in the financial reports. Auditors look at everything regarding an investment's existence and valuation. They test sample accruals and typically verify the accuracy of any fee the fund manager receives, such as performance or management fees. The fund managers, or their administrators, have to be able to support and provide all the documentation behind these numbers.

There are always last-minute questions, especially around investment valuation. Our clients are private investment managers, so their investments are not typically publicly traded —it's not like you can go to Nasdaq and get the price. Because there is no open market readily available to value private investments, fund managers need to develop valuation methods that require professional judgment. To do the job right requires a high-level knowledge of finance principles and a deep understanding of capital markets and how transactions are negotiated and executed. And over the last 18 months, in particular, the lack of transactions means fund managers don’t have the required valuation inputs and data to give proper valuations, making things more challenging for them.

From the fund administrator's perspective, the biggest pain point is the substantially increased workload. In addition to the regular work at year-end, which culminates in issuing financials and investor statements, the fund administrators must also provide audit support, addressing the auditor’s questions and requests and preparing the annual audited financials. With that comes many tight deadlines that pressure the team to deliver accurate and timely information.

The key deliverable is the annual audited financial statements, which, no matter how much you plan ahead, always seems to get finalized at the last minute. Mainly, that is because there are a lot of parties involved that need to review and ultimately opine on the accuracy and completeness of the information disclosed in the financial statements, including the auditors that are looking at all the financial information, supporting general ledger accounts, as well as the client.

Be upfront and talk about what and when auditors will need things from your team. It needs to be discussed early in the process.

Then it comes down to whether the fund manager is outsourcing their back-office functions or whether all that work is done in-house. If the latter, there is a great deal more for the fund manager to consider because they are responsible for the official books and records, and they must provide all the evidence and documentation the auditors will need. Nevertheless, whether you have a fund administrator or not, it comes down to having a clear grasp of accounting and reporting, as well as an understanding of the timing and expectations of the audit. Especially if you do everything in-house, you need to be able to stand behind the numbers you’re reporting and recording. It is all about robust documentation and the ability to support all material transactions and amounts that took place during the period under audit.

Another thing to consider is having clear documentation of your operating model. Ultimately, auditors will ask, “Show me how you do the cash reconciliation and what controls you have in place to ensure all the cash activities and transactions are done correctly and are being reviewed.” In addition to verifying financial information, the auditors will be focused on the internal control environment to evaluate the health of the operating model so they can determine the risk of errors and potential fraud. All these things will influence the scope and type of audit procedures they will need to conduct.

If the accounting and reporting activities are done in-house, fund managers must first have the mindset that they are the official books and records, and with that comes a lot of responsibility. Ultimately, they have to demonstrate to the auditors they have the proper expertise to process, account, and report on fund financial transactions, they have the right people in place to carry out these functions, and their policies and procedures have enough controls to ensure information is reported correctly and reviewed. Auditors evaluate the internal control environment—that a manager has a separate team doing cash reconciliation than doing treasury functions and that the environment makes it less likely for a mistake or illegal activity to occur. Auditors use that framework to decide how much they have to test. The manager must create that environment, supply their teams with the right technology, and employ the right people. Even though there is much you can automate, you still need humans with very specific expertise to analyze and report information. Understanding the magnitude of what it means to be your own official books or records is the key.

They need to make sure everyone is on the same page when it comes to roles and responsibilities and have a clear understanding of what work is going to be done by the fund administrator. Once they have a third-party provider, the manager needs to know who their main contact is and who the team is. They should ask the question—what is the staffing model? Is it a pool model, where whoever on the team is available will process a capital transaction? Do they have a designated team?

Communication is another key element. Do you want to establish standing weekly calls, are you okay with monthly calls, or do you prefer email as a way of communicating? They also want to be clear on the format of period close deliverables and financial reports the fund manager will need so they can report on the fund activities and performance to their investors.

Some managers mistakenly think that once they employ a third-party administrator, they are off the hook for the integrity and accuracy of financial reporting. But at the end of the day, it’s the fund manager who has the fiduciary duty to the investors, which means the manager is ultimately responsible for what is being reported to the investors. The fund managers have the freedom to design their operations—they can do it in-house or outsource that function—but they are still responsible for the accuracy of the information.

The SEC is putting more emphasis on greater transparency in the information reported to investors, especially as it relates to fund performance, fees, and expenses. They want fund managers to send quarterly investor statements with those statistics or metrics, as well as showing how that calculation has been done.

Another requirement is that advisers will be required to undergo a financial statement audit at least annually and also upon liquidation, and independent auditors must conduct those audits. Investment advisers will still be required to go through annual surprise examinations or obtain an audit of financial statements.

Technology needs to become an integral part of an operating model. It produces greater efficiencies and quality, which allows team members to spend more time on high-level work and provide analysis, which ultimately adds value to our clients. And that’s what it’s really all about. You don’t want to be perceived as someone who just sits behind a screen and sends routine reports. You want to be a business partner that can provide some insight into what’s going on in the industry.

Leveraging technology is also important to attracting talented professionals and has a high impact on the quality of the service. Specifically, regarding audit season, technology like online portals helps to share information securely and efficiently between all partners. Document digitization is also becoming prevalent in all functions, especially regarding audit evidence.

Early planning plays a huge role in the success of audit season. Schedule that kickoff call now and establish a very specific timeline with clearly outlined expectations to ensure auditors can communicate with the manager or with the fund administrator as needed. Figure out how you will handle issues that come up last minute. Who is going to be your point of contact? Who has the authority to approve certain changes that must be made for the audit report to be issued? Early planning and regular check-ins also allow the auditors to update the fund administrator— on what they need to be aware of regarding financial statement disclosures and what’s new. If you can get going and start reports and disclosures early, it will really be a massive time saver at the end.