Independent auditor

Fund auditors examine and verify financial statements. They may also offer general accounting and tax advisory services. Along with prime brokersA financial institution that provides comprehensive services to hedge funds including trade execution, custody, securities lending, margin financing, and capital introduction., reputable independent auditors give investors confidence that funds accurately report their investment activities. Auditors examine various aspects of manager operations and may identify accounting errors or fraudulent activities. However, audits do not guarantee that a fund will make money or avoid losses.

Fund auditors create annual audited financial statements and prepare tax documentation. During their annual audit procedures, auditors conduct random testing of various ledger accounts and portfolio valuations. When they discover irregularities, auditors may perform more comprehensive investigations.

The audit process requires qualified independent accounting firms to comprehensively examine fund operations. They review various aspects of a manager's activities to identify potential accounting errors or fraud. Auditors examine the fund's books and records, verify that assets actually exist, test internal controls, and ensure the fund complies with applicable accounting standards.

Independent audits serve as a cornerstone of hedge fund regulatory compliance, particularly under the SEC's custody ruleAdherence to regulatory requirements governing the safekeeping of client assets, including segregation and auditing obligations. framework. For most hedge fund managers, the critical component involves the "pooled vehicle annual audit exception." This exception allows managers to avoid certain custody rule requirements if they meet specific conditions.

Managers must deliver annual audited financial statements to each hedge fund investor within 120 days of the end of the fund's fiscal year. Funds of funds get 180 days to complete this requirement. Managers must also conduct an audit when the fund liquidates.

Timely delivery of annual audited financial statements with a clean audit opinionUnqualified audit opinions indicating that financial statements are fairly presented in all material respects and comply with applicable accounting standards without any reservations. helps satisfy the custody rule requirements. Additionally, funds must conduct a final audit when they liquidate and promptly distribute those results to investors. This ensures transparency throughout the fund's entire lifecycle.

Registered hedge funds face more stringent audit and reporting obligations compared to private funds. They must provide both audited annual reports and unaudited semi-annual reports to investors within 60 days of each period's end. These reports become public documents that are filed with the SEC and must include detailed financial statements showing all portfolio holdings.

Selecting a reputable independent auditor has become crucial for fraud prevention in the hedge fund industry. Multiple high-profile frauds in the alternative investment sector involved either internal fraud without external oversight or funds using unknown or questionable external service providers.

The Bernie Madoff case illustrated this risk clearly. Investigation revealed that Madoff employed an obscure two-person accounting firm rather than a large, reputable auditor. Madoff's accountant approved the books without conducting proper due diligence to verify whether the business actually possessed the claimed assets. Similarly, the Bayou Group established a fictitious accounting firm to audit their funds, providing fraudulent results to investors.

Beyond financial statement audits, auditors may also advise funds on regulatory compliance and product structuring. They may coordinate with fund counsel on issues such as state, federal and international tax requirements. The fund, rather than the management company, generally pays the auditor's fees.

Institutional and other investors commonly contact fund service providers directly for due diligence purposes. This helps them verify that funds operate consistently with best practices and reduces fraud risk.

The quality and reputation of a fund's auditor, along with how quickly the audit is completed, are now standard evaluation criteria for sophisticated investors assessing hedge fund investments. The audit requirement has become increasingly important in the hedge fund industry. It serves not only as a regulatory compliance measure but also as a key component of due diligenceThe comprehensive investigation and evaluation process conducted before making an investment or business decision. by institutional investors.