Subsequent Events Considerations for Investment Companies

Posted by John Braun on Oct 21, 2021 9:44:17 PM

Preparing the Financial Statements

As part of the preparation of financial statements, Management should actively search for events occurring and information available after the fiscal year-end but before financial statements are issued– commonly known as subsequent events. In the context of an investment company, most subsequent event considerations of a material nature are one of a handful of events – for example valuation of investments, litigation, liquidation or reorganization, or significant capital changes.

There are two types of subsequent events per Generally Accepted Accounting Principles (“GAAP”) that should be considered for materiality and relevance to an entity’s financial statements:

Subsequent Events Considerations for Investment Companies

Recognized Subsequent Events – An entity shall recognize in the financial statements the effects of subsequent events that provide additional evidence about conditions that existed as of the date of the balance sheet.

Example – Many funds hold underlying funds as investments that periodically compute a net asset value in accordance with GAAP for investment companies. Daily priced funds usually value these holdings using the last net asset value provided by the underlying fund’s administrator and then estimating the change in value of that investment on a daily basis through various approaches. If the underlying fund provides a new net asset value during the subsequent period that better reflects the value of the investment as of the fiscal year-end, Management should consider adjusting the financial statements.

Non-recognized Subsequent Events – An entity shall not recognize in the financial statements the effects of subsequent events that provide additional evidence about conditions that did not exist as of the balance sheet date, but should consider the need for disclosure.

Example – Litigation occurs periodically with investment companies causing consideration of both contingent gains and losses. Management should consider any outstanding litigation and its impact on the financial statements or disclosures. In the case of a contingent gain, GAAP generally concludes that contingent gains are not to be recognized until the investment company acquires an enforceable right. If the enforceable right is acquired during the subsequent period, then the condition did not exist as of the balance sheet date. However, it should definitely be considered as a non-recognized subsequent event assuming it’s of a material nature.

Preparers of financial statements should be alert for and consider any subsequent events and the potential impact on the financial statements using the above criteria.

Audit Considerations

Just as GAAP requires consideration of subsequent events as part of the preparation of financial statements, Generally Accepted Auditing Standards (“GAAS”) require an auditor to search for and consider subsequent events and the potential impact on the financial statements. In addition, the auditor is also required to consider and evaluate control deficiencies to financial reporting that might arise from the lack of consideration or lack of disclosure and/or accounting for subsequent events.

A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow Management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis.

If, as a result of audit procedures, the auditor determines a control deficiency exists, then the auditor must determine what level of deficiency exists per GAAS:

Material Weakness - A deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis.

It should be noted that in the context of investment companies, which are SEC issuers, material weaknesses are required to be communicated in the internal control report filed with Form N-CEN. A deficiency of a lesser magnitude does not require any public filing.

Significant Deficiency - A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company's financial reporting.

Other Deficiencies – An identified deficiency that does not meet the level of Significant Deficiency or Material Weakness.

Practical Considerations

It should be noted that the levels of control deficiency defined above do not require that an audit adjustment of a certain dollar threshold be uncovered (i.e. – just because an audit adjustment resulting from a control deficiency is not material does not mean that a material weakness does not exist). The definitions are focused on the potential for misstatement. This leaves much judgment to the auditor in the way of determining the specific designation of the control deficiency. However, if an auditor does uncover an audit adjustment of a material nature as a result of subsequent events audit procedures, it would be very difficult to defend a position that the control deficiency leading to that adjustment is not one of a material nature, therefore resulting in a material weakness.

When faced with identified control deficiencies, an auditor typically considers:

Could the control deficiency result in a material misstatement of the financial statements?

  • Yes - If it could, or the audit uncovers a material adjustment to the financial statements, then a Material Weakness exists.

  • No - If audit procedures uncover an adjustment that is not material to the financial statements, or the auditor does not believe that the control deficiency could result in a material adjustment, then consideration should be given as to whether the deficiency rises to the level of a Significant Deficiency.

Would this deficiency be of interest to a Director, or someone charged with oversight?

  • Yes – Does this deficiency rises to the level of something that an auditor would present at an Audit Committee meeting? If the answer is yes, then the deficiency should be identified as Significant. Note that many times control deficiencies have associated audit adjustments that are presented to the Directors as an attachment to the management representation letter, so the auditor may be discussing the issue with the Director group anyway.

  • No - If we have determined that the deficiency does not rise to the level of either a Significant Deficiency or Material Weakness, then we will consider whether the finding still warrants a written presentation to Management and/or the Directors or just a verbal discussion with Management. Note that the standards do contemplate the fact that the auditor can conclude that a deficiency does not rise to the level of warranting the attention of the Director group but still write up the deficiency for Management and share the communication with the Director group.

In conclusion, to avoid control deficiencies relating to the consideration of subsequent events and their potential impact on financial statements, Management should be sure to consider any events occurring using the criteria noted above relative to subsequent events. Many times, communicating with your auditor about potential adjustments and/or disclosure considerations relating to subsequent events can avoid a control deficiency.

 

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