Real estate private equity fund managers are typically accustomed to obtaining financial statement audits of the fund, and it is important to know that stand-alone audits of the lower-level property investments can be just as relevant and important.
In a typical real estate private equity fund structure, each investment property is commonly held in an LLC governed by its own operating agreement. These LLCs are may also hold the related mortgages on the properties. The most common reasons for obtaining a property audit are as follows:
- Requirement in the operating agreement of the LLC
- Requirement by the lender in the mortgage loan agreement
- Fund manager wants a level of assurance related to:
- Accuracy of property management’s accounting records
- Financial records used for comparability across the portfolio
- Net operating income used in fund valuations
Unlike the specialized accounting and reporting requirements for investment companies under Accounting Standards Codification Topic 946 Financial Services – Investment Companies, property level financial statements often have more flexibility in selecting the basis of accounting. When an entity’s accounting method is not dictated by a governing body, the fund manager should consider which basis is a more beneficial financial management reporting tool and the impact this basis has on the property’s financial results and presentation. Some of the different financial reporting method include:
- Generally accepted accounting principles (GAAP)
- Income tax basis
- International financial reporting standards (IFRS)
- Special purpose basis of accounting
There are different accounting requirements under each basis that should be considered before choosing which basis to select.
There are several things a fund manager can do to prepare for and facilitate a successful property level audit:
- Designate an audit point person from your team.
- Understand the significant accounting cycles and obtain and/or prepare a write-up of the major business processes and internal controls at the property.
- Evaluate whether the internal controls are effectively designed and implemented.
- Obtain and/or develop and prepare a financial reporting and close checklist.
- Review the complete financial reporting package of schedules and relevant documents that will be provided to the auditors to determine whether supporting schedules agree to the general ledger and sufficient documentation and evidence exist that support those schedules
- Review the financial statements, whether prepared by property management or another external party to determine whether they appear reasonable and complete based on your understanding of the property, as well as understanding of any significant fluctuations.
Property level audits can be a relevant and useful tool for fund managers and, when properly planned, can be performed efficiently and effectively.