Fund audits: understanding key FSLIs and audit risk areas

Investment funds remain among the more complex and judgement-heavy entities to audit. Their structure, regulatory environment, valuation methodologies and investor-related transactions create audit risks that differ significantly from those found in trading entities.

This article focuses on the practical audit considerations surrounding collective investment schemes (CISs), with particular attention on the financial statement line items (FSLIs) that typically drive audit risk and the complexities surrounding valuation, completeness, investor transactions and financial risk disclosures.

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What is a Collective Investment Scheme?

A Collective Investment Scheme (CIS) pools funds from multiple investors and invests them in accordance with a defined investment strategy, a strategy which is outlined within the Offering Documents of the Fund in question. In exchange for their investment, investors receive units or shares that represent their interest in the fund. The value of these units is typically based on the Net Asset Value (NAV) of the underlying investments.

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SICAVs and regulation

In Malta, the most common legal form for investment funds is the Investment Company with Variable Share Capital (SICAV). SICAVs are typically open-ended, allowing investors to enter and exit the fund by buying (subscribing) or selling (redeeming) shares or units in the fund. Share capital accordingly fluctuates in response to these investor subscriptions and redemptions.

SICAVs are regulated under the Investment Services Act and must be licensed or notified with the Malta Financial Services Authority (MFSA). Depending on the investor target market and investment strategy, funds may be structured as one of the following:

• UCITS or non-UCITS retail funds
• Alternative Investment Funds (AIFs)
• Notified Alternative Investment Funds (NAIFs)
• Professional Investor Funds (PIFs)
• Notified Professional Investor Funds (NPIFs)

Each licence category carries different regulatory, governance, and disclosure requirements, an important consideration when planning audit procedures.

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Offering documents

Key audit documents for auditors to obtain and review from the client are The Prospectus / Offering Memorandum and Offering Supplements. Such documents would define the investment objectives and restrictions of the fund, subscriptions and redemptions mechanics, share classes and fee structures, roles of key service providers, risk factors and regulatory disclosures and other relevant details.

Through reference to these documents, auditors can properly understand the fund’s business model, assess compliance with investment restrictions, validate fee calculations and also identify FSLI’s with higher inherent risk.

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Compliance and governance considerations

In addition to the review of the Offering Documentation and in line with the requirements of ISA 315 (Revised), fund audits would also require a strong understanding of compliance arrangements, including the fund’s licence status and regulatory obligations, the role of the compliance officer and MLRO, anti-money laundering controls, particularly over subscriptions and correspondence with regulators (MFSA, FIAU).

Audit procedures commonly involve reviewing the MFSA financial services register, board minutes, compliance reports, MLRO reports, administrator reports, breaches logs and complaints registers.

The auditor is required to verify that any breaches occurring during the year are duly disclosed in the director’s report, as stipulated within the MFSA rulebooks.

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Key FSLIs in a fund audit

The FSLIs that drive audit risk in an investment fund would typically include:

• Cash
• Investments
• Share capital
• Expenses, and
• Net investment income

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Testing share capital and NAV

Investor shares are generally puttable instruments under IAS 32, allowing investors to redeem units for cash. As a result, they are presented outside equity, usually as net assets attributable to holders of redeemable shares.

When testing share capital and the NAV, the key audit areas that the auditor would need to focus on would include subscriptions and redemptions, unit pricing and dealing dates, minimum investment and holding requirements and opening and closing NAV reconciliations.

NAV testing is typically performed per share class and reconciled back to audited prior-year figures.

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Auditing investments

Prior to responding to risk in accordance with ISA 330, auditors must first identify and assess risks in line with ISA 315 (Revised). This would require auditors to understand the nature of the investments held by the fund, including whether they consist of equity instruments, debt instruments or derivates, the purpose for which those investments are held, such as for trading, for long-term capital appreciation or to generate yield; their classification under IFRS 9, as well as whether investments are held directly by the fund or through a custodian.

The primary assertions that need to be addressed when auditing investments would include existence, rights and obligations, valuations, completeness, classification and presentation.

IFRS 13 categorises investments into:

• Level 1 – quoted prices in active markets
• Level 2 – observable inputs other than quoted prices
• Level 3 – unobservable inputs requiring significant judgement

Level 3 investments, such as private equity or illiquid assets, represent heightened audit risk and frequently involve management experts, requiring additional audit work under ISA 540 and ISA 500.

Auditors must also assess the fund’s accounting policy for recognising investment transactions, including whether these are recorded on a trade date or settlement date basis, and ensure that the policy is applied consistently in accordance with IFRS 9.

Investment restrictions imposed by the MFSA or disclosed in offering documents must also be reviewed and tested, given breaches could have regulatory and disclosure implications.

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Auditing fund expenses

Fund expenses are typically divided into NAV based expenses and non-NAV based expenses. When one speaks of NAV based expenses, this typically refers to management fees, administration expenses or custody fees, and such fees are ‘linked’ to the NAV of the fund in question.

When carrying out audit procedures on expenses, audit testing would typically focus on ensuring alignment between expenses stipulated in the offering documentation, and those booked in the accounts. Auditors should further confirm accurate fee calculations based on the GAV or the NAV, while also review performance fee mechanics, including highwater marks and hurdle rates.

Performance fees require careful recalculation and an understanding of the crystallisation frequency.

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Cash and investment income

Cash is audited through bank confirmations, reconciliations and credit risk assessments. Certain short-term instruments may qualify as cash equivalents if they meet IAS 7 criteria.

Investment income testing would typically include the review of dividend warrants and bank statements in support of dividend income, performing a reasonability test on interest income, with amounts traced to bank statements, and assessing whether gains have been appropriately classified as realised or unrealised.

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Financial statements and disclosures

Fund financial statements differ from those of operating entities primarily because all assets and liabilities are generally classified as current, traditional equity is typically not presented, and a statement of changes in net assets attributable to holders of redeemable shares is used instead.

Additional disclosure requirements in the financial statements also arise from the Fifth Schedule of the Companies Act and IFRS 7 financial risk disclosures. IFRS 7 requires both qualitative and quantitative disclosures, including sensitivity analysis for market risks and maturity analyses for liquidity risk.

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Conclusion

Auditing investment funds requires a deep understanding of fund structures, regulatory frameworks and valuation methodologies. The audit approach must be customised and grounded in a thorough understanding of the fund’s offering documents and operating environment, including a thorough assessment of potential risks of material misstatement.