First-Year Audits of Real Estate Investment Funds – What You Need to KnowAnchin AlertNovember 9, 2021
First-Year Audits of Real Estate Investment Funds – What You Need to Know
Companies often view audits of financial statements as stressful and overwhelming, especially if they are being audited for the first time. The audit process, regardless of the size of the entity being audited, includes extensive procedures that the auditors are required to perform to provide an opinion on the entity’s financial statements. Understanding the audit process and developing a collaborative relationship with your auditors will lead to a more effective and efficient first-year process. Outlined below are several items to consider.
Establish Your Accounting Team
A financial statement audit is not a low-cost endeavor and can be made more costly by an ineffective accounting team, requiring auditors to perform additional procedures to be able to issue the opinion. Consideration should be given to hiring an internal accounting team versus hiring a fund administrator or outsourced accounting support, including the associated costs of each, while balancing the risk of turnover, which is mitigated with a fund administrator or outsourced support.
Initial Step-Up Compliance and Policies
Leading up to your audit, having the below documents and other information prepared ahead of time will allow for a smoother audit:
- All organizational documents, including purchase and sale agreements, subscription agreements, side letters and management agreements. For a first-year audit, expect that gathering these documents could take a significant amount of time. These documents will be your baseline for future audits and is generally called the ‘permanent file.’
- Determine the Basis of Accounting - An entity’s financial statements may be presented on various bases of accounting, including generally accepted accounting principles (“GAAP”), or other comprehensive basis other than GAAP, such as income tax basis. Ensure that you are familiar with the basis of accounting requirements outlined in the partnership or operating agreements, and that the books and records are kept on such basis. Note that once an entity’s investment manager registers as a Registered Investment Advisor (“RIA”), GAAP will be the only permitted basis of accounting.
- Descriptions of significant processes and the key internal controls (for example: cash receipts and disbursements, oversight of property management companies, financial statement close, IT and cybersecurity, etc.). The auditors will walk through the significant processes to understand the entity’s business set up and evaluate whether such processes and the related internal controls are designed and implemented properly.
- Accounting policies, including those around income recognition, valuations, estimates, the identification of related party transactions and others.
- A major focus of an audit will be the entity’s valuation policy. Often, there may be inconsistencies between valuation policies contained within the legal documents and what is acceptable under GAAP. Such inconsistencies will need to be carefully addressed to ensure GAAP compliance, while managing what is outlined in legal documents. The valuation policy should document whether valuations will be completed internally or if third-party appraisers will be engaged. Documentation around break periods and when/how often the valuations are needed will also be important, if applicable.
- If the investment manager is an RIA, consider engaging a compliance provider to assist with documenting and maintaining policies, procedures and other compliance-related matters. In addition, once an RIA, the auditors will be subject to significantly more strict independence rules and will not be able to provide the same level of support.
After you have chosen your audit firm and executed an engagement letter, expect to receive an initial request list from the audit team. Establish an understanding with the audit firm on a secure method of transferring documents. It is best to use a centralized database, rather than exchanging information by email.
It is also preferable if the auditors only have one or two points of contact at your company. Be prepared to provide a complete set of books and records, including supporting calculations, waterfall and IRR calculations, as well as a complete set of financial statements and the accompanying footnotes. It is very important to support and continue collaborating with your auditors as they finalize their audit of your financial statements.
The Audit Timeline
Understanding the timeline of an audit is just as important as the audit itself. For calendar year audits, generally, at the end of the third quarter or the beginning of the fourth quarter, an engagement letter outlining the scope of work will be executed with the auditors. Pertinent legal documents will be gathered, and the auditors will perform walkthroughs of the entity’s significant processes to obtain an understanding of the business, processes and controls. In addition, the auditors will design the nature, timing and extent of the audit procedures, and will generally test transactions through an interim date. It is good practice to debrief with the auditors at this point to determine if any gaps exist in financial reporting or in the control environment that would need to be addressed timely before the calendar year-end.
The year-end audit procedures will commence immediately following the end of the fund’s fiscal year and will continue until the issuance of the financial statements. Generally, the date of the financial statement issuance will depend on the date determined in the operating agreement. Generally, RIAs must issue financial statements within 120 days of year end.
Communication and Goals
As you prepare for the audit, consider whether you’ve dedicated enough employee bandwidth to support auditor requests. If you’ve hired a fund administrator to support the management team, understand who the main point of contact is and monitor the communication between the fund administrator and the auditors.
You should also set objectives for the timely completion of the audit, including various internal deadlines. That would include having books and records in order, and monthly and year-end processes completed on time before auditors can commence audit procedures. The pre-audit phase is also a good time to review risks and communicate management’s philosophy about internal controls, including “tone at the top.”
In this early stage, good communication with your audit firm is a priority. Let them know your timetable for providing them information and collaborate with the auditors to ensure they have sufficient time to perform their audit. This will also allow the auditors to prepare and schedule an audit team to begin work. Lastly, engage in continuous dialogue with the auditors, and make sure to ask questions early and often.
For more information on what to expect in a first-year audit, please contact Anchin’s Emerging Manager Platform team or your Anchin Relationship Partner.