Plan management is responsible for establishing internal controls over financial reporting, including proper valuation and appropriate presentation in conformity with U.S. generally accepted accounting principles (GAAP). Hard to value assets have recently been identified as an area of focus by the Department of Labor and there’s no better time to tighten up your plan’s controls.
Since alternative investments are not publicly traded, valuation requires management to use the best information available about the assumptions that market participants would use in pricing them. Merely relying upon partnership reports or custodial statements is not sufficient. Suggested processes include:
- Obtaining audited financial statements of the investment. Such statements should coincide with the plan’s reporting date and be accompanied by an unmodified report of independent auditors.
- Reading unaudited financial statements and accompanying notes and carefully assessing them.
- Gaining an understanding of the valuation methodology used and gauging its reasonableness.
- Evaluating data underlying the investment valuation (e.g. asset listings, appraisals) and assumptions used. Consideration should be given to each investment’s strategy and available market data.
In addition to the determination of investments’ fair values, internal controls over financial reporting should be sufficient to track historical cost. Accurate historical cost (generally the investment’s purchase price) is required to compute net appreciation/depreciation in fair value for proper reporting in accordance with GAAP. Procedures should be sufficient to identify common errors such as the following:
- Upon change in custodian, new custodian records assets at market value on the date transferred and treats it as historical cost.
- Custodian adjusts assets’ historical cost to match market value.
Finally, controls should be designed to capture information required to be reported in notes to the plan’s financial statements. Since alternative investments are most often categorized as level 3 investments, disclosures are usually quite detailed and include both quantitative and qualitative information regarding assumptions, liquidity, etc. In many cases such investments generate unrelated business income, which must be calculated and reported.
Processes and controls over financial reporting should be developed by management and thoroughly documented. Procedures should be assigned to personnel with the knowledge and skill to understand and appropriately execute them and should be followed consistently to protect the plan, its participants and fiduciaries. Certain processes may be outsourced; however management must have sufficient information to evaluate and independently challenge the information.
For additional information on designing internal controls, please contact us.
We highly recommend you confer with your Miller Kaplan advisor to understand your specific situation and how this impacts you.