An investment that is not one of the three traditional asset types such as stocks, bond and cash are considered as an alternative investment. “These types of investments include hedge funds, managed futures, real estate, commodities and derivative contracts.” (www.investopedia.com). These are subject to less regulation and use leverage and derivative instruments to optimize their returns. “In spite of many pensions and private endowments beginning to invest in these funds, the portion apportioned to them is still small usually less than 10%.” (www.investopedia.com). An alternative investment differs from publicly traded investments in three main ways: The alternative assets can be purchased in a privately negotiated transaction. Alternative investments are illiquid.
The investors invest as combined limited partners.
Based on the characteristics and other related supporting information, I think two out of five investment funds would be considered as an alternative investment: Cloudy High-Yield Hedge Strategies and Cloudy Real Estate All Stars because They are private investment vehicles.
They are not registered with the SEC and
The quoted market prices are not readily available.
Cloudy High-Yield Hedge Strategies:
This consist of 10 high- yield hedge funds consisting of both private and public stocks that use leverage and derivative instruments to maximize the returns. Although, there is a portion of funds consisting of public stocks; the portion that is made up of private stocks would cause to characterize these as an alternative investments. Cloudy Real Estate All Stars:
This fund consists of primarily high-quality real estate properties. Although, 20 percent of the fund invested is in publicly traded real estate funds, treasuries, and other government securities, the majority (80 percent) of the fund is alternative in nature.
As per AU 330-11, the audit evidence doesn’t seem appropriate because it is not reliable and relevant in terms of existence and valuation. Further, AU 330-04 defines confirmation as “the process of obtaining and evaluating a direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions.” The process includes— Selecting items for which confirmations are to be requested. Designing the confirmation request.
Communicating the confirmation request to the appropriate third party. Obtaining the response from the third party.
Evaluating the information, or lack thereof, provided by the third party about the audit objectives, including the reliability of that information.
In this case, the confirmations do not provide sufficient competent audit evidence to support the existence of the investments. The main reason for this is that the information was not obtained from a third party as stated in the auditing standards. As discussed in audit procedure, the confirmation replies were received directly from Union which is not a third party. Because Union is the trustee and custodian of the pension fund, any information it would provide relating to the fund would potentially have inherent risk. As per the standards, the information received from Union would not meet the requirements as a sufficient confirmation.
In order to acquire necessary evidence, through confirmation, to support the existence of the investments, the information would at least have to come directly from Cloudy Investments which it didn’t happen in this case. Also, even if the information would have been received from Cloudy Investments, there would still have to be some other audit procedure that needs to be performed to reduce the risk that the investments were nonexistent. For instance, in order to confirm the balances exist, the auditors may send a negative confirmation request to Cloudy Investments and ask them to fill in required information concerning account balances and return it directly to the auditors.
In addition, the auditors have failed to take the control reliance and specific risks related to investment have not been identified; therefore, a high level of inspection is necessary to confirm that the information is not a fraud. According to AU 332-21, this may require auditors to perform additional substantive procedures for existence or occurrence assertions such as: Confirmation with the issuer of the security.
Confirmation with the holder of the security, including securities in electronic form, or with the counterparty to the derivative. Confirmation of settled transactions with the broker-dealer or counterparty. Confirmation of unsettled transactions with the broker-dealer or counterparty. Physical inspection of the security or derivative contract. Reading executed partnership or similar agreements.
Vouching relevant cash receipts and disbursements.
Inspecting supporting documentation for subsequent realization or settlement after the end of the reporting period. In this case, the confirmations do not represent sufficient competent audit evidence to support the valuation of the investment. As discussed earlier, the information is not received from the third party (Cloud Investments) rather obtained from Union (trustee and custodian). As per AU 330-04, the information received from Union would not satisfy the requirement of sufficient confirmation. Since Union is the trustee and custodian of the pension fund, any information relating either to support the existence or the valuation of investment would have potential inherent risk. In order to obtain necessary evidence to support that the investments are valued appropriately, the confirmation must have to come directly from Cloudy Investments. If the information comes from Cloudy, still there need to be other required audit procedure to reduce the risk that the investments were valued adequately. 1. Since Cloudy Retirement Intermediate- Term U.S. Treasury is registered with SEC and its valuation can be easily evaluated, there is no additional audit procedure required [AU 332-36].
2. Cloudy High yield Hedge Strategies assuming:
a. The audit team received a detailed confirmation:
Examine the complete listing of investments and correlated debt or other obligations of the fund.
b. The audit team did not receive a detailed confirmation of the underlying investments: If the audit team did not receive the detailed confirmation of the underlying investments as of the plan’s year-end, auditors may gain necessary understanding of the fund through other activities such as, “conducting the timely interviews with the fund management team to understand the fund’s strategy, positions, and valuation methodologies, and matching the data obtained from the fund manager with other available information, such as sector data, indexes and cash contributions and distributions. Such data could be further validated with information regarding the essential investments obtained through the annual audited financial statements of the alternative investment.” (Valuing and Reporting Plan Investment, 2011).
(n.d.). Retrieved 11 10, 2013, from www.investopedia.com.
Valuing and Reporting Plan Investment. (2011, July). Retrieved November 10, 2013, from www.aicpa.org.