Effective audit of financial instruments

 

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial instruments are used by financial and non-financial entities of all sizes for a variety of purposes. Some entities have large holdings of financial instruments and vast volumes of transactions while other entities may only engage in a few financial instrument transactions. Entities used financial instruments for different purposes, for example:

● Hedging purposes (that is, to change an existing risk profile to which an entity is exposed).

● Trading purposes (for example, to enable an entity to take a risk position to benefit from short term market movements); and

● Investment purposes (for example, to enable an entity to benefit from long term investment returns).

The complexity of financial instruments may increase the business risks for entities and risk of material misstatement of financial statements. This may happen when management and those charged with governance:

·        Do not fully understand the risks of using financial instruments and have insufficient skills and experience to manage those risks.

·        Do not have the expertise to value them appropriately in accordance with the applicable financial reporting framework.

·        Do not have sufficient controls in place over financial instrument activities; or

·        Inappropriately hedge risks or speculate.

A competent auditor needs to be able to identify risks related to financial statements that may lead to a misstatement in the financial statements. If an auditor does not maintain a focus on those risks that may lead to a misstatement in the financial statements, the audit will be a very long process and not at all efficient.

Stages of auditing financial instruments

An audit of financial instruments may include the following steps:

·        Understanding the accounting and disclosure requirements.

·        Understanding the financial instruments to which the entity is exposed, and their purpose and risks

·        Determining whether specialized skills and knowledge are needed in the audit.

·        Understanding and evaluating the system of internal control in light of the entity’s financial instrument transactions and the information systems that fall within the scope of the audit.

·        Understanding management’s process for valuing financial instruments, including whether management has used an expert or a service organization; and

·        Assessing and responding to the risk of material misstatement.

·        Evaluating the presentation and disclosure.

·        Communicating to those charged with governance.

·        Obtaining Written Representations from an entity’s management.

Understanding the accounting and disclosure requirements when auditing financial instruments

The use of reasonable estimates is an essential part of accounting of financial instruments. The auditor's objective is to obtain sufficient appropriate audit evidence about whether accounting estimates are reasonable and related disclosures are adequate.

The requirements of the applicable financial reporting framework regarding financial instruments may themselves be complex and require extensive disclosures.

Certain financial reporting frameworks require consideration of accounting and disclosure areas such as:

● Hedge accounting.

● Accounting for “Day 1” profits or losses.

● Recognition and derecognition of financial instrument transactions.

● Own credit risk; and

● Risk transfer and derecognition, in particular where the entity has been involved in the origination and structuring of complex financial instruments.

Understanding the financial instruments to which the entity is exposed, and their purpose and risks.

The complexity of financial instruments makes it difficult to identify certain elements of risk to which these financial instruments are exposed.

Examples of matters that may be considered when obtaining an understanding of the entity’s financial instruments include:

·        To which types of financial instruments, the entity is exposed.

·        The use to which they are put.

·        Management’s and, where appropriate, those charged with governance’s understanding of the financial instruments, their use and the accounting requirements.

·     Their exact terms and characteristics so that their implications can be fully understood and, in particular where transactions are linked, the overall impact of the financial instrument transactions.

·        How they fit into the entity’s overall risk management strategy.

·        Management’s process for identifying, and accounting for embedded derivatives.

Understanding management’s process for valuing financial instruments, including whether management has used an expert or a service organization.

Management’s valuation process is the technique that management may use to value their financial instruments. These techniques may include:

·        Observable (market) prices.

·        Recent transactions.

·        Models.

·      A third-party pricing source, such as a pricing service or broker quote. Pricing services provide entities with prices and price-related data for a variety of financial instruments, often performing daily valuations of large numbers of financial instruments. These valuations may be made by collecting market data and prices from a wide variety of sources, including market makers, and, in certain instances, using internal valuations techniques to derive estimated fair values. Pricing services are often used as a source of prices based on level 2 inputs.

·        A valuation expert.

Fair presentation financial reporting frameworks often use fair value hierarchies, for example those used in IFRS and U.S. GAAP. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). The auditor evaluates available evidence and understands both the fair value hierarchy and the risk of management bias in management’s categorization of financial instruments in the fair value hierarchy.

Understanding and evaluating the system of internal control in light of the entity’s financial instrument transactions.

The company’s system of internal control relating to financial instruments includes the following elements:

·      The Entity’s Control Environment. The control environment includes commitment to competent use of financial instruments, participation by those charged with governance in oversight over the entity’s financial instrument activities, organizational structure to run financial instruments activities, assignment of authority and responsibility related to financial instruments, human resource policies and practices, use of service organizations to buy, sell, record and evaluate the financial instruments.

·     The Entity’s Risk Assessment Process. An entity’s risk assessment process exists to establish how management identifies business risks that derive from its use of financial instruments and decides upon actions to manage them.

·        The Entity’s Information Systems. The main objective of an entity’s information system is that it is capable of capturing and recording all the transactions accurately, settling them, valuing them, and producing information to enable the financial instruments to be risk managed and for controls to be monitored.

·    The Entity’s Control Activities. Control activities over financial instrument includes an appropriate authorization process, adequate segregation of duties, and other policies and procedures designed to ensure that the entity’s control objectives are met.

·        Monitoring of Controls. The entity’s ongoing monitoring activities are designed to detect and correct any deficiencies in the effectiveness of controls over transactions for financial instruments and their valuation.

 Auditors understand and evaluate entity`s control system using tests of control such as inquiries about internal controls, inspection of documents supporting controls, reperformance of control procedures, testing of internal controls operating on computerized systems or over the overall IT function, observation of controls to consider the manner in which the control is being operated.

The understanding of the accounting and disclosure requirements, the financial instruments to which the entity is exposed, the entity`s system of internal control enables the auditor to identify and assess the risks of material misstatement at the financial statement and assertion levels, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement.

Assessing the risk of material misstatements related to financial instruments.

When assessing the risk of material misstatements auditors take into consideration the following issues:

a)      The use of more complex financial instruments, such as those that have a high level of uncertainty and variability of future cash flows, may lead to an increased risk of material misstatement, particularly regarding valuation.

b)     Other matters affecting the risk of material misstatement: the volume of financial instruments, the terms of the financial instruments, the nature of financial instruments.

c)      The risk of material misstatement may also arise due to the existence of financial instruments that management has not previously identified or disclosed to the auditor.

Assessing the risk of material misstatements related to financial instruments auditors also must consider fraud risk factors such as:

·      Incentives for fraudulent financial reporting by employees may exist where compensation schemes are dependent on returns made from the use of financial instruments.

·        Difficult financial market conditions may give rise to increased incentives for management or employees to engage in fraudulent financial reporting: to protect personal bonuses, to hide employee or management fraud or error, to avoid breaching regulatory, liquidity or borrowing limits or to avoid reporting losses.

·         Misappropriation of assets and fraudulent financial reporting may often involve override of controls. This may include override of controls over data, assumptions and detailed process controls that allow losses and theft to be hidden.

Responses to the assessed risks of material misstatement

The auditor’s may response to the assessed risk of material misstatements by performing:

(a)   Only tests of controls to achieve an effective response to the assessed risk of material misstatement for a particular assertion.

(b)   Only substantive procedures for particular assertions and, therefore, excludes the effect of controls from the relevant risk assessment. This may be because the auditor’s risk assessment procedures have not identified any effective controls relevant to the assertion, or because testing controls would be inefficient.

(c)   A combined approach using both tests of controls and substantive procedures is an effective approach.

A substantive procedure is an audit procedure designed to detect material misstatements at the assertion level.

Substantive procedures comprise:

(i)         Tests of details (of classes of transactions, account balances, and disclosures); and

(ii)         Substantive analytical procedures.

While analytical procedures undertaken by the auditor can be effective as risk assessment procedures to provide the auditor with information about an entity’s business, they may be less effective as substantive procedures when performed alone due to complexity of financial instruments and the nature of non-routine transactions.

Tests of details may be more useful in auditing financial instruments than analytical procedures. But an auditor should select proper items for testing. In some cases, the financial instrument portfolio will comprise instruments with varying complexity and risk. In such cases, judgmental sampling may be useful. For the selected items the auditor may consider performing some of the following audit procedures:

● Examining contractual documentation to understand the terms of the security, the underlying collateral and the rights of each class of security holder.

 ● Inquiring about management’s process of estimating cash flows.

● Evaluating the reasonableness of assumptions, such as prepayment rates, default rates and loss severities.

● Obtaining an understanding of the method used to determine the cash flow waterfall.

● Comparing the results of the fair value measurement with the valuations of other securities with similar underlying collateral and terms.

● Reperforming calculations.

Communicating with those charged with governance with respect to financial instruments.

With respect to financial instruments, matters to be communicated to those charged with governance may include:

·     The risks associated with financial instrument activities.

·  Significant deficiencies in the design or operation of the systems of internal control or risk management relating to the entity’s financial instrument activities that the auditor has identified during the audit.

·   Significant difficulties encountered when obtaining sufficient appropriate audit evidence relating to valuations performed by management or a management’s expert, for example, where management is unable to obtain an understanding of the valuation methodology, assumptions and data used by the management’s experts, and such information is not made available to the auditor by management’ s expert.

·    Significant differences in judgments between the auditor and management or a management’s expert regarding valuations.

·    The potential effects on the entity’s financial statements of material risks and exposures required to be disclosed in the financial statements, including the measurement uncertainty associated with financial instruments.

·   The auditor’s views about the appropriateness of the selection of accounting policies and presentation of financial instrument transactions in the financial statements.

·   The auditor’s views about the qualitative aspects of the entity’s accounting practices and financial reporting for financial instruments; or

·   A lack of comprehensive and clearly stated policies for the purchase, sale and holding of financial instruments, including operational controls, procedures for designating financial instruments as hedges, and monitoring exposures.

In conclusion, the complexity of financial instruments may increase the business risks for entities and risk of material misstatement of financial statements, therefore, in order for the audit of financial instruments to be effective, it may be necessary to involve experts or specialists in certain areas, as well as focus on those risks that may lead to misstatement of financial statements.