Crypto Fund Interim Planning– Best Practices for a Successful Year-End Engagement

December 2021

AM_Crypto-Fund-Interim-Planning-Best-Practices_Web-Header.jpg

Download PDF Version

For any fund audit/tax relationship, proper project planning and transparent communication throughout the year form the foundation for a successful service experience.  With the growing rise in crypto-focused funds and traditional venture or hedge funds with material crypto positions, as well as the continued evolution of new crypto investment products, structures, and regulator guidance, we thought it beneficial to highlight interim planning best practices helping to contribute to a smooth year-end.
 

1. Service Provider and Management Considerations

At interim, management should clearly communicate with its service providers any and all significant changes that have occurred prior to the commencement of the engagement.Specifically:
  1. Service provider and management updates - Management should ensure audit and tax professionals have updated service provider contact information and are notified if there have been any changes in management.  Each service provider should be made aware of service provider changes, as each service provider has customized reporting and operational nuances which should affect the scope of work. Some service providers may have limited to no crypto experience, so it can be helpful for management to discuss with its current service provider group their experiences with potential new service providers prior to making a switch.
  2. Authorized access – Approving online access privileges to audit and tax professionals will save time as the team can download needed reports directly from the custodian website or administrator portal. Many crypto platforms are currently limited on report availability compared to traditional custodian platforms, so it will be helpful for teams to assess if there are any holes in reporting capabilities.
  3. Auditor change - If switching auditors, management should ensure the transition is clearly communicated to the predecessor audit firm. Management should authorize the predecessor CPA firm to communicate with the successor firm and allow access to review prior year workpapers.
 

2. Interim Planning – Setting Expectations

Timelines are essential to ensure that all parties set a clear expectation for meeting key objectives and dates for deliverables.Management should understand the state, SEC, foreign jurisdiction, and / or legal document prescribed deadlines that it must meet. Interim presents an opportune time to set a mutual roadmap so that all service providers are aware of and agree upon key deliverable dates.
  1. Timeline - Establish a timeline that management, the administrator, and CPA firm agree upon.  The timeline should include both audit and tax and include following milestones:
    • NAV package and financial statement delivery to management by the administrator
    • Management sign off of NAV package and financial statements
    • NAV package and financial statements delivered to auditor
    • Auditor reviews NAV package and signs off on final numbers
    • Auditor completes review of draft financial statements
    • Tax team provides draft K1s to management
    • Issuance of financial statement
    • Issuance of K1’s
  2. If other offices or jurisdictions are involved in the work or sign-off (i.e. Cayman Islands), obtain an understanding for lead time other offices need and ensure this is incorporated into the timeline.
  3. In situations where a fund uses two different CPA firms to complete its audit and tax compliance work, it is especially important to ensure the two CPA firms are aligned on when the audit team has signed off and confirmed no additional changes are needed to fund NAV and partner allocations so that the tax CPA firm can release final K1s and reduce the risk of restatement.
 

3. Audit Considerations

The following are key elements revolving around the audit that should be thoroughly vetted between management and their auditor.
  1. New entity and legal document updates - Discuss any new legal entities, such as SPVs, blockers, or feeder funds. Auditors can discuss audit and / or disclosure requirements related to the custody rule as well as any other regulatory bodies, such as CIMA. Discuss any significant updates to terms or drafting of new documents.  Provide side letters or updated agreements.
  2. Partner allocations – Discuss non-standard items with auditors including special fee arrangements, activity in side-pockets, changes to lock-up status, or non-standard fee calculations.   Blocker and / or offshore funds may be introduced to fund structuring to account for ECI and UBTI, which should be discussed with the administrator and audit, and tax teams to ensure all are aligned on treatment.
  3. Related party transactions – This is a key area of focus for the regulators. Discuss all related party relationships and transactions with the auditor and determine financial statement disclosure implications, including:
    • Board positions with portfolio companies and associated income treatment, if applicable
    • Special expense waivers, payments, or other arrangements with affiliated parties
    • Co-investments with affiliated entities
    • Receivables and payables from affiliated entities
    • Proper expense allocation between funds and management company
    • Management fee and incentive allocation/fee
 

4. Portfolio Specific Audit Considerations

Portfolio composition is a key area of focus at year-end. Keeping service providers apprised in a timely manner on portfolio composition changes will allow teams to properly scope year-end work.
  1. Custody - At interim, ensure the auditor has a complete listing of custodians used and all wallet addresses utilized during the year. This list should also be revisited and updated as of December 31. Failure to provide a complete listing may result in additional procedures and could result in delays or additional fees. It is also extremely important to make the auditor aware as soon as possible if tokens are not being stored in a segregated on-chain wallet that the auditor can validate on the blockchain. Situations where tokens are held in exchange / custodian accounts that are not in a segregated wallet address specific to the fund may require management to move token balances to a wallet address that the auditor can validate on the blockchain. These situations should be discussed with the fund auditor well before year-end. Any microtransaction testing performed to prove ownership of specific wallets selected can also be performed at interim. It will be also be helpful to understand whether custodians will provide a SOC1 Type II report on internal controls, which auditors may consider as they formulate their audit plan as it relates to custody or other transactional testing. Understanding when the report will be available and confirming the time frame covered will be helpful questions to ask. Ideally, the auditor will be able to review the report during interim so that year-end procedures can be formulated before year-end work begins. Obtaining the report too late in the process may result in the audit team not having sufficient time to incorporate into its audit plan.
  2. Valuation policy - Review the Accounting for and Auditing of Digital Assets practice aid developed by the AICPA and CIMA, which was updated in May 2021 and ensure that there is alignment with the fund’s valuation policy. The valuation policy should clearly address how management determines the principal market, discuss the levelling policy adopted by management, and also specify the time at which the valuation is struck. Additionally, review the valuation methodology financial statement footnote language to ensure it has been tailored to management’s specific approach vs. using boiler plate language.
  3. Investment Activity and Related Financial Statement Disclosure – Discuss significant changes to the portfolio. If new types of income are being earned through lending, yield farming, staking, etc., or new types of investments such as derivatives, NFTs or private Level 3 investments have been made, additional financial statement disclosures may triggered if material. Disclosure language can be crafted and discussed prior to December 31.
  4. Private portfolio company updates – Provide an operational update for private portfolio companies. Provide supporting documents for new rounds of financing during the year. Discuss expected rounds to close before year-end. While valuation overstatement is oftentimes what funds may focus on, it is also important that a complete review is performed to ensure investments are not materially understated, especially with the explosive growth within the crypto market. Being conservative is not necessarily the right GAAP answer if information exists supporting a higher valuation. Private portfolio companies that have not had a recent round of financing and a valuation model is being used, discuss the valuation approach to confirm the audit team is comfortable with the methodology being used. Models and inputs can be tested at an interim date and then updated at year-end to front-load work. For newer investment types such as NFTs, engage in conversation with the fund administrator and auditor to determine if the fund’s valuation methodology and data sources are reasonable and if questions can be answered early in the process. If the audit team plans on utilizing internal valuation experts, request that those involved in the year-end sign off also be included in the conversation at interim.  
  5. Reasonableness of unobservable inputs - Discuss the reasonableness of inputs used in valuation models. If unobservable inputs exist, these will be included in the financial statement footnotes and having a proper understanding of what is required can save time at year-end.
  6. Level 3 investment back testing and retrospective reviews – Compare subsequent sales and financing or actual results versus estimates used by management in the prior year.
  7. 3rd Party Valuations - If third party valuation experts will be used, discuss with the auditors the support to be provided and management’s involvement and procedures after the valuation reports are received. Management bears the ultimate responsibility for the valuations even if a third party valuation expert has been engaged, so it is important that management be actively involved in understanding the expert’s credentials, inputs and methodologies used by the expert, and conclusions reached.
  8. Investments in crypto funds – Similar to investments in traditional alternative investment funds, it will be important to highlight to the auditor if investments have been made in other crypto funds. If material, additional financial statement disclosures will be triggered. It will be important to verify when audited financial statements, investment confirmations, and K1s will be provided by the underlying investee fund. For crypto funds in particular, auditors will look closely at the reputation of the underlying fund auditor and the experience they have within the crypto space. It will also be important to understand in advance if the underlying fund expects to receive an unqualified opinion or if any qualifications will be made.
 

5. Financial Statements Considerations

A common deficiency in internal control relates to financial statement preparation. Although management may hire an administrator or consultant to prepare the financial statements, management bears the ultimate responsibility over the financial statements.
  1. New accounting pronouncements – Discuss with management, the auditor and the administrator any new accounting pronouncements and their effect on recording of transactions and financial statement presentation and disclosures. Updates can be made by management and the administrator during interim and can be reviewed by the auditor prior to year end to minimize edits made during year-end fieldwork. As of the publication date of this piece, there have been no new or revised accounting pronouncements that would significantly change the financial statements of a fund from the prior year. Changes within the fund as detailed in Section IV above and related disclosure implications should be discussed with the fund auditor. 
    • Financial statement preparation review – Discuss any challenges encountered during the prior year financial statement preparation process. If specific footnotes were problematic, discuss and ensure management, the administrator and the auditor are all on the same page as to the detailed supporting schedules required and footnote preparation responsibility and ultimate presentation.
    • Prior year adjusting journal entries or passed adjusting journal entries – Review to determine if any adjustments existed in the prior year and if there will be any repeat issues in the current year. If so, proactively adjusting prior to net asset value (NAV) package and financial statement finalization should save time prior to issuance. The prior year management representation letter will typically include entries made and can be discussed at interim for teams to proactively address.
    • Other disclosures – Derivative disclosure requirements, including volume and gain/loss disclosure requirements, as well as Level 3 investment disclosure requirements, including the Level 3 purchase, transfer and unobservable input tables, are common disclosure items that can prove time-consuming at year end. Crypto funds should also have enhanced risk disclosures further detailing key risks pertaining to the crypto marketplace. Many of these risks are included within a fund’s private placement memorandum. Proactively address these disclosures at interim to ensure the administrator and the auditor have discussed whether prior year support was sufficient and to save time during year-end fieldwork.
  2. Internal Controls
    • Prior year issues – Discuss any issues raised in the prior year to ensure that the proper changes have been made to mitigate identified deficiencies. Lack of SOC1 reports for key custodians used, segregation of duties and financial statement reporting are common deficiency areas specific to crypto funds.
    • Control environment – Discuss with the audit team any changes in internal control processes. Additionally, prime brokers, custodians, fund administrators and other service providers may provide SOC1 reports to management outlining their internal control environment. Updated SOC1 reports can be provided to the audit team to help in the assessment of the internal control environment. If the full period under audit is not covered by the SOC 1 report, a bridge memo can be requested for the stub period not covered by the report. In situations where third party service providers are not utilized and controls procedures are conducted in-house, management should be prepared to discuss key controls in areas such as cash management, financial reporting, and trading activity and be prepared to walk through transactions with the audit team as well as provide supporting transaction documentation. It is common for audit teams to schedule live walkthroughs with funds to better understand and obtain support on how crypto transactions are authorized, transacted and processed.
  3. Tax Considerations: Proper tax reporting of crypto trading is generally a more challenging and time-consuming process compared to standard equity trading. The Infrastructure Investment and Jobs Act, signed by President Biden on November 15, 2021, expands information reporting requirements for cryptocurrency and requires those engaging in crypto transactions over $10,000 during the year to report certain information to the IRS. As a refresher, the IRS treats virtual currency as property (not currency), for U.S. federal tax purposes. Long-term capital gains rates apply if the crypto asset is held for investment purposes and is held for more than 1 year (similar to investing in standard securities). Income from crypto mining activities is considered ordinary income. Other more specific considerations include the following:
    • API feeds and tax report availability – Ensure your tax professionals have reviewed API feed transaction reports or other tax reports available from exchanges and custodians before year end to ensure they are able to obtain all information needed to perform year-end tax testing. In addition to transactions conducted in USD or other fiat currency, token for token transactions or tokens exchanged for goods or services (both considered taxable events) should also be included on transaction reports.
    • ECI / UBTI / fund structuring – For funds that are mining, staking, yield-farming or lending crypto, speak with your tax team to determine impacts on non-U.S. and tax-exempt investors and if the proper fund structure is in place to accommodate these investors appropriately.
    • Forks – Hard forks could result in ordinary income based on whether new tokens are received. Bring these situations to the attention of your tax professionals.
    • State filing requirements – Discuss if there are new limited partners from new states, which may trigger additional state filling requirements.
    • Tax estimates – Discuss with your tax professionals if tax estimates may be beneficial for limited partners.
    • Updated partner information – Ensure the administrator and your tax professionals have an updated list of limited partners with updated addresses and EIN/SSNs.
    • New offices – If additional offices opened in new jurisdictions during the year, discuss whether there are any additional tax implications to consider. We have found that within the crypto space, a higher percentage of shops have management spread out across the world versus working in one single location.
    • Foreign trading and accounts – If investment transactions have been made during the year in new foreign countries (countries in which investing has not occurred in the past), discuss with the tax team whether any potential tax liabilities exist. In addition, crypto held in foreign accounts may trigger FinCEN Report 114 or Form 8938 filings, which should be discussed with your tax professional.
    • Contributed/distributed tokens – Discuss with your tax professional and administrator the audit and tax implications of contributions and distributions of tokens. Contributions of tokens will result in additional tax lot tracking which will need to start upon contribution.
    • Potential changes in U.S. tax laws – Recent proposals within Congress would change the way certain gains and losses from digital assets are recognized. As of the publication date of this piece, the proposed tax legislation has not been enacted but, if passed, would apply to transactions after December 31, 2021. Discuss the proposals with your tax professional early to help you better understand how the tax implications of your trading strategy might be affected.