Audited financial statements are an important tool for investors planning to invest in a hedge fund; this is because these statements allow investors to understand the comprehensive operational due diligence. Due diligence is an important term for potential investors as it relates to the transparency of a hedge fund regarding examining the fund’s operations, management and verification of information.
An auditor is a qualified individual capable of auditing a business. Auditing is an investigation and verification process of a business’ records and procedures. There are two types of auditors; internal and external.
An internal auditor is a member of staff whose primary job is to audit his or her company. An external auditor is an independent auditor not employed by the company. An external auditor evaluates the effectiveness of a company’s public relations carried out by an external agency.
Hedge funds are not required for auditing due to the private partnership structure, but many hedge funds choose to have their funds audited in an attempt to attract investors by showing the quality and transparency of their fund. The purpose of auditing is to verify data, to ensure consistency and to correct errors.
There are several services provided by auditing and accounting firms for hedge funds. Certain hedge fund strategies and structures require more auditing scrutiny in comparison to other funds. KPMG was awarded the HFM award for “Best Hedge Fund Audit Services Firm” in the year 2011. These are some of the services provided by KMPG in their accounting and auditing division for hedge funds:
- Financial statement audit
- GAAP and IFRS experts
- Agreed upon procedures
- Regulatory audit and assurance
- Accounting advice
- Accounting standards conversion
- Financial close optimisation
The financial statements provided by an auditor, on a fund (client) display a vast amount of information regarding not only the fund’s financial position but also the fund’s expense levels, decisions made by the fund, as well as opinions on the fund by the auditor. The opinions made by an auditor usually falls into two categories; qualified and unqualified.
A qualified opinion occurs when an auditor states which aspects of the company’s statement he or she does not agree with (this occurs concerning the correlation of the figures between that of the independent auditor and the accounts department of the fund). There are extreme cases where an auditor expresses no opinion, in such circumstances the scope of the audit is rendered insufficient.
An unqualified opinion by an auditor states that there are no material misstatements. Material misstatements in this regard would refer to the importance of a fact, for example, if there were a material fact, it would change the decision of the investor. A material misstatement may result in rendering a contract void. The problem with unqualified statements is that it may lead an investor into a false sense of security. Corgentum (2010) has issued a list of common misconceptions regarding auditor information in hedge funds:
- An audit consists of a detailed review of every position taken by a hedge fund
- There is no discretion amongst auditors in designing and implementing an audit plan
- All auditors set the same scope of audit and materiality levels consistently
- Auditors must perform on-site visits with each hedge fund manager that they audit
- Auditors must provide a detailed review of hedge fund’s counterparties and service providers
GAAP stands for General Accepted Accounting Principles, and IFRS stands for International Financial Reporting Standards. GAAP is a set of rules, conventions, standards and procedures for reporting financial information as determined by the Financial Accounting Standards Board. The Financial Accounting Standards Board also updates and publishes the International Financial Reporting Standards (IFRS) in an attempt to standardise accepted accounting principles across international borders. IFRS is used to determine how various types of transactions should be recorded in balance sheets and general ledgers. An expert in this field is important for hedge funds as it is vital that the fund’s audit report be appealing to both local and international investors.
Agreed upon procedures refers to an agreement made between a fund an auditor. A fund may agree with an auditor to revise or audit only a particular section or particular sections of the fund to verify the assets in that particular area to determine the performance. Regulatory audits and assurance refer to the restrictions, licences and laws imposed on a company by the government. Regulatory audits are done to ensure that the company complies with all laws and legal requirements of the country that they are currently operating in and to avoid any legal matters regarding the mandatory compliance. Assurance is similar to insurance, as it provides cover for an event that is certain to happen.
Accounting advice relates to an evaluation of the fund’s assets and liabilities, statement of comprehensive income and the statement of financial position. Fund auditors will highlight areas that need further attention as well as areas that are currently doing well. The “account standards conversion” is made according to the types of accounting GAAP principles. The fund auditors must be able to bridge the gap between the different financial systems in a way that will enable the fund manager as well as potential investors to understand the audited report fully.
Financial close refers to the fund’s financial year end. Optimisation of the financial close is the task of assembling the fund portfolio at year end in a way that increases return for the current level of risk taken by the fund or vice versa where the risk is reduced at the same level of return. Optimisation may be done by creating a more efficient workforce, changing the number of indicators used or rethinking the fund’s strategic plan by taking away what does not work and enhancing the areas that are currently working.