I have been approached by several private equity funds and hedge funds to propose on performing their annual audits. Each were audited by the “Big 4″ and looking to save some audit fees by moving toward the next tier audit firm.
They all had the same concern – how are you going to view our fair value measurements for the portfolio companies? My answer was the same… “As long as you are following FASB ASC 820-10-35 and your audit firm followed AU section 328 – I should be able to get comfortable with your measurements.”
Ok in all honesty, I didn’t say that. Well, at least not in those “technical terms” because I didn’t want to sound like a nerd, even though I am one.
The reason for their concern is that determining the value of the assets held in a fund is crucial. For one thing, the fund earns its money from charging a fee based on asset value and earnings on those assets, often times, before the asset is actually sold. In addition, the Fund attracts additional investors based on its performance. Thus, continually overvaluing a portfolio company could mean big dollars to a fund manager.
As an auditor, I have to make a determination of management’s integrity, how motivated are they by profits and manipulating them and I also must understand and test the validity of its estimate of value for its underlying assets.
Here is an extract from the AICPA Audit Guide on Investments Companies:
2.52 The objective of the estimating procedures is to state the securities at the amount at which they could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The term current transaction means realization in an orderly disposition over a reasonable period. All relevant factors generally should be considered in selecting the method of estimating in good faith the fair value of each kind of security.
2.53 In estimating in good faith the fair value of a particular financial instrument, the board or its designee (the valuation committee) generally should, to the extent necessary, take into consideration all indications of fair value that are available. This guide does not purport to delineate all factors that may be considered.
The hardest thing to audit is fair value of a portfolio company that is not publicly traded on an exchange. Industry accounting standards allow management to determine a good faith estimate. Yes, I said a “good faith estimate.” In the words of Gordon Gecko, “Greed is Good.” How would he determine a good faith estimate? And would you believe it?