Issue link: https://maltatoday.uberflip.com/i/1313317
maltatoday | SUNDAY • 29 NOVEMBER 2020 6 AUDITING ON a layman's term, the concept of Funds is such a generic term and without doubt an- yone can relate to. It could mean, cash, as- sets, capital, resources, money or any form of wealth. On the other hand, the concept of auditing fund companies can be per- ceived to be challenging. Similarly, in a cor- porate world, what causes confusion is the different terminologies when referring to a fund company, that is, mutual funds, hedge funds, UCITS, closed/open ended funds, feeder funds, master funds, etc. This is an attempt to enlighten you a little bit. First, understand the structure. Fund com- panies can be private, or publicly owned, which is in the business of investing the pooled capital of investors in financial secu- rities. One form of structure could be in the form of Master- feeder structure whereby Investors put capital into their respective feeder funds, which ultimately invest assets into a centralized vehicle known as the mas- ter fund. The master fund is responsible for making all portfolio investments and con- ducting all trading activity. This scenario would typically also be referred to as fund of funds structure whereby the feeder funds' investments are only shares in the master fund/s. This would mean that the NAV of the feeder fund is driven by the NAV of mas- ter fund. While the NAV of the master fund, is in turn driven by the NAV of the portfolio of investments. In this kind of structure, the risk (i.e. correctness of the pricing & valua- tion of investments, etc.) would fall on the master funds' investments). I would like to be clear here that the feeder fund and the master fund are both separate legal entities. Another structure would be an umbrella fund. This would mean one single legal enti- ty but with several distinct sub-funds, which in effect operates a fund company. This kind of structure is also commonly referred to as SICAV (an open-ended collective invest- ment scheme common in western Europe). The creation of a sub-fund is mostly to ad- dress a specific investment strategy, that would vary from one to another. Next let's get to know the parties to a fund company which are: the fund manager (as the name suggests manages the portfolio of investments and would typical- ly be a related party to the fund company), the administrators (third parties who act as accountants responsible for the preparation of the NAV, amongst other things), and the custodians/bankers (third parties who hold the portfolio of investments and cash on behalf of the Fund company). This would mean that in the case of a feeder fund (who only has investments in a master fund), one audit procedure to address the correctness of its investment is to write to the custodian of the feeder fund to request confirmation of the quantity of the shares (held by the feed- er fund in the master fund) and to the ad- ministrators of the master fund to confirm the value/price/NAV of the shares. Since auditors are relying on these third parties, it would help reviewing the credibility of the administrators and custodians. Wait, let me stop and define first Net Asset Value or NAV. This is the "equity" for fund companies which would mean the assets less liabilities. It is a common practice also to calculate and measure the NAV per share or unit price of the fund at a specific time. This is to mark the value of the investors' shares. I also would like to give emphasis on the crucial role of the Administrator. Similar to a normal company, if the accounting func- tion is messed up, that would mean we ex- pect issues to arise. Therefore, it will be ex- tremely helpful if the administrator would have controls in place for their key func- tions which would include but not limited to portfolio transaction processing, pricing and portfolio reconciliation. It is typical for the administrator to have ISAE3402/SSAE 18 (type 2) report for a certain period (say 1 October 2019 to 30 September 2020). Such report will help auditors rely on the controls in place and the auditors can do top-up testing to cover period not covered by the report (1 October 2020 to 31 Decem- ber 2020 for a fiscal year ending 31 Decem- ber 2020). A bridging letter confirmation, issued by the administrator, would also add comfort to confirm to the auditors that dur- ing the period not covered by the report, the controls remain to be suitably designed to achieve their control objectives and that there have been no significant changes. After getting to know a little bit the struc- ture, one would think that if an investor would invest his\her money in a fund com- pany, surely, there should be some sort of agreement. This would be in a form of a prospectus which is a public document that contains the Funds' strategy and all other key information (such as service providers, licence held and any restrictions, fees, target jurisdictions, etc.). That would not be all, to protect the investors, Fund companies (and the service providers) are regulated. Fund companies are therefore bound to keep up with government regulations with the help of a compliance officer (another service provider). This makes it a little bit tricky be- cause each jurisdiction would have its own terminology in categorizing funds apart from other laws set by a bigger governing body (i.e. European Union directives). So, for example, the European Union has es- tablished a mutual recognition regime that allows funds regulated in one country to be sold in all other countries in the European Union, but only if they comply with certain requirements. The directive establishing this regime is the Co-ordination of Laws, Regulations and Administrative Provisions Relating to Undertakings for Collective Investment in Transferable Securities (UCITS) Directive 2009, and funds that comply with its require- ments are known as UCITS funds. In Malta (and other European jurisdictions), funds are also referred to as Collective Investment Schemes. Investment Services Act, Cap 370 (and its subsidiary legislation) is the prin- cipal legislative enactment governing the funds industry in Malta. It essentially trans- poses the legislation issued by the European Union such as the UCITS directive (there are other directives, such as MIFID and AIFMD). Collective Investment Schemes domiciled in Malta require a licence from MFSA, similarly for other service providers. Licences can vary from Professional Inves- tor Fund (PIF) to Alternative Investor Fund, UCITS and Notified Investment Funds. The variation is from the types of investors, size of Assets Under Management, marketing passporting provisions, transparency rules, investment restrictions and so on. I can go on and on and pretty sure you have a lot of questions at this point. The key takeaway here is to recognize that compliance aspect is therefore an area that should be looked into when auditing fund companies. This can be done through re- viewing compliance rules applicable to the fund company with the help of the com- pliance officer, reviewing compliance re- ports and checking any notice/breaches from the regulator's website. Any breach or non-compliance can lead to penalties and in the worst-case scenario, the revocation of the licence which can lead to going concern issues. The last and probably the most challeng- ing part in my opinion is the understanding of the investments especially when dealing with portfolio of investments that are not listed or classified at level 1 or 2 under the fair value hierarchy as contemplated in IF- RS 13, Fair Value Measurement. I will speak briefly only about verification of quantity and pricing. A good starting point is the portfolio reconciliation prepared by the administrator. Such schedule should show how the quantity and pricing has been veri- fied externally. If the investments are listed, prices can be confirmed easily since these are published (such as on Bloomberg). For other investments, auditors refer to the ba- sis used by the administrators which could be statements, workings, valuations or other basis and naturally auditors should chal- lenge their sources. Regarding the quantity, auditors should request the Custodian to confirm the quantity of investments held by the fund companies. As a last note, post fieldwork date (as part of test of subsequent procedures), auditors should also request for the most recent portfolio reconciliation available to confirm if prices have remained the same or if they have decreased (which then would indicate an impairment). You will appreciate that there is a lot to ex- plore on this topic. But hope that this helped you in building a basic understanding of au- diting fund companies. Conrad Borg Audit and Assurance Partner RSM Malta Auditing a fund company, simplified