Debra Martin Loyola Law School Sue Menditto NACUBO

Debra Martin, Loyola Law School Sue Menditto, NACUBO Roger Patterson, UNC – Chapel Hill Mary Wheeler, Cornell University Accounting Principles Council Update Tuesday, July 11

AICPA Alternative Investments Task Force

Alternative Investments What are alternative investments? Hedge funds, private equity, venture capital funds, commodity funds, fund-offunds (to name a few) – typically in the form of limited liability partnerships, limited liability corporations, trusts … Why are we talking about them? Auditing challenges posed by investments in non-publicly traded entities raised by 2005 AICPA interpretation…left controllers scrambling for FY 05 year-end audits with many questions still unanswered heading into FY 06 year-end.

AICPA Auditing Interpretation • AU Section 9332, “Auditing Investments in Securities Where a Readily Determinable Fair Market Value Does Not Exit” • Alternative Investments • Interpretation clarifies rules regarding testing measurement of fair value • In such circumstances simply receiving a confirmation from a third party does not in and of itself constitute adequate audit evidence with respect to a fair market value assertion. • The interpretation does not provide for what would constitute adequate evidence

AICPA Auditing Interpretations • If unable to audit the existence and/or valuation of the investments, as of balance sheet date, auditor should consider a scope limitation • To the best of our knowledge in fiscal 2005 no college or university received a scope limitation opinion related to the valuation of alternative investments. • Conclusion…auditors and higher education institutions found another way to get comfortable with both existence and valuation.

Alternative Investments Task Force • AICPA Alternative Investments Task Force • Objective: to consider accounting and auditing issues with respect to alternative investments • NACUBO represented by Dale Larson, University of Dallas and John Kroll, University of Chicago • Deliverable: Clarified guidance • Task force recommended: • Management takes full responsibility for oversight and monitoring • Auditor reviews and tests management’s processes and oversight • Existence and valuation - GP statements, annual audit, cash flows and estimation calculations • Auditor confirmations ask for detailed investment information

Audit Issues Task Force Response • On July 7, “Alternative Investments – Audit considerations” Practice Aid Draft issued • For review by Alternative Investment Task Force members. • Target Date – July 12 – for release of final practice aid • Check with your auditor • Check www. aicpa. org

FY 06 Audits • • NACUBO Understanding of the AICPA Practice Aid Existence Assertion – do the investments exist at a given date and have recorded transactions occurred during a given period Valuation Assertion - are alternative investments reflected in the financial statements (of the institution) at appropriate amounts (fair value for higher education)

FY 06 Audits – AICPA Practice Aid • Risk • • • Inherent Control Materiality • • Significance Complexity • Management’s responsibility • Auditor’s responsibility

FY 06 Audits - Existence • Auditor must have adequate understanding of relevant internal controls to plan the approach to verifying existence • If verifying the existence is required • Confirmation in the aggregate is not sufficient • Confirmation should be on a security by security basis • If Confirmation does not contain sufficient detail, the auditor should perform other procedures – for example: • Observing management site visits • Reviewing partnership of other legal agreements • Review cash receipts and disbursements

FY 06 Audits - Valuation • Management • responsible for making the fair value measurements and disclosures included in the financial statements • needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures • Selects appropriate valuation methods • Identifies and supports significant assumptions used • Prepares the valuation • Ensures that presentation and disclosure of fair value is in accordance with GAAP • Above responsibilities can not be outsourced or assigned to anyone outside of the entity’s management

FY 06 Audits – General Conclusion • Auditor’s approach will be based on their assessment of the risk of material misstatement in the financial statements • Professional judgment regarding inherent and control risk • Quantitative and qualitative decisions • • • Significance of alternative investments to the F/S Nature and complexity Liquidity Management’s processes and controls Available information documenting management’s assertions • Talk to your auditors! • Review with your audit committee

Preparing for the Audit • How should institutions prepare for FY 06 year-end audits? • Talk to your auditors! • Documentation of policies regarding: pre-investment and postinvestment due diligence and monitoring, understanding the fund’s investment strategy, method and calculation of fair value • Enhance communication between the Controller’s office, the Investment office and the Treasurer’s office • Don’t surprise your audit committee

Sample Best Practices for NFP’s… Pre Investment Monitoring Procedures Pre-Investment • Hold a face to face meeting with the management team • Conduct on-site visit(s) • Evaluate investment strategy, process, portfolio, and historical track record • Document review by investment office staff, including offering memorandums, legal agreements, and financial statements • Evaluate how specific allocation fits within the asset class portfolio • Solicit information regarding the General Partner team from third parties • Do reference checks • Do third party background checks on senior professionals • Review and negotiate legal agreements…consider using outside counsel • Complete a formal investment memo/write-up for approval

Sample Best Practices for NFP’s… Post Investment Monitoring Procedures Post-investment • Conduct regular in person or telephonic meetings with the GP • Conduct on-site visits • Review fund communications including financial statements and shareholder communications • Review valuation of portfolio valuations for reasonableness • Monitor portfolio performance: • Compare performance to benchmark returns • Review portfolio holdings on a regular basis • If the investment strategy changes in mid-stream…check it out • Monitor firm/manager: • Review press reports for significant management changes • Monitor staffing levels • Monitor size of assets under management for consistency with business plan

Sample Best Practices for NFP’s… Assessing Fair Values Assessing the reasonableness of fair values provided by investment managers: • Document policies with respect to alternative investments including due diligence in manager/fund selection (fund administration, including accounting, controls, and valuation methodology should be areas of inquiry in due diligence). • Obtain an understanding of the fund’s strategies and holdings, ascertaining the nature of the underlying investments (i. e. marketable securities, derivatives, private companies, real estate, etc).

Sample Best Practices for NFP’s… Assessing Fair Values • Consider requesting the detail of the portfolio (underlying securities). • Obtain the fund’s audited financial statements noting: (a) whether the independent auditor’s opinion is unqualified on a GAAP basis or modified; (b) the audit firm (ascertain credentials, if you are unfamiliar with the audit firm); (c) disclosed valuation methodologies; (d) other disclosures which may impact on valuation or the institution’s own disclosures; (e) date of independent auditor’s report (f) subsequent events footnote, if any (g) develop historical data on the change in valuation in the lag period (calendar year end or March 31 roll-forward for alternative and June 30 report date for institution)

More on Alternative Investments • • July / August Business Officer, “In the Know”, Dale Larson www. nacubo. org www. aicpa. org Possible webcast – stay tuned • Accounting firms • Task Force members