In light of the financial crisis and changes to international auditing and accounting standards, the UK Financial Reporting Council proposed revisions to its guidance for outside auditors of company financial statements on financial instruments. Generally, the auditor must obtain an understanding of how the firm manages and controls its exposure to financial instruments, including how the firm ensures that all instruments are accurately recorded, that the valuations are accurate and reviewed, that risk limits are applied, and that duties are segregated between those transacting, settling and accounting for financial instruments. Risk management and professional skepticism are important components of the revised guidance.
For firms transacting financial instruments, an understanding of the firm’s related risk management processes and risk appetite may identify risks of material misstatement. It is not the job of the auditor to determine the amount of risk a firm should take or how it should monitor and manage risk, said the FRC, but it is important for the auditor to consider and develop a point of view on this because poor risk management processes can affect the audit in a number of indirect ways by, for example, exposing a firm to levels of risk that breach legal or regulatory restrictions. Importantly, poor risk management can make it more difficult to obtain an understanding of the impact of financial instruments on the firm as a whole. And, in extreme circumstances, inadequate risk management can increase the risk of a going concern problem. For example, financial instruments losing value or becoming illiquid can threaten the ability of the entity to continue as a going concern.
The guidance posits that professional skepticism is necessary to the critical assessment of audit evidence and assists the auditor in remaining alert for possible indications of management bias. Professional skepticism can include questioning contradictory audit evidence and the reliability of documents, as well as questioning responses to inquiries and other information obtained from management and those charged with governance. It also includes being alert to conditions that may indicate possible misstatement due to error or fraud and considering the sufficiency and appropriateness of audit evidence obtained in light of the circumstances.
The proposed guidance states that maintaining professional skepticism throughout the audit is necessary if the auditor is to reduce the risks of overlooking unusual circumstances, over generalizing when drawing conclusions from audit observations, or using inappropriate assumptions in determining the nature, timing, and extent of the audit procedures and evaluating the results thereof.
In addition, evaluating audit evidence for assertions about financial instruments requires considerable judgment because the assertions, especially those about valuation, may be based on highly subjective assumptions or be particularly sensitive to changes in the underlying assumptions. For example, valuation assertions on financial instruments may be based on assumptions about the occurrence of future events for which expectations are difficult to develop or about conditions expected to exist a long time. Thus, competent persons could reach different conclusions about valuation estimates or estimates of valuation ranges. Considerable judgment also may be required in evaluating audit evidence for assertions based on features of the financial instrument and applicable accounting principles, including underlying criteria, that are both extremely complex.
The need for professional skepticism increases with the complexity of financial instruments, said the FRC, for example, with regard to evaluating whether sufficient appropriate audit evidence has been obtained, which can be particularly challenging when models are used or in determining if markets are inactive. Professional skepticism also ratchets up with evaluating management’s judgments, and the potential for management bias, in applying the firm’s applicable financial reporting framework, in particular management’s choice of valuation techniques, use of assumptions in valuation techniques, and addressing circumstances in which the auditor’s judgments and management’s judgments differ. Moreover, a good dose of professional skepticism is needed in drawing conclusions based on the audit evidence obtained, for example assessing the reasonableness of valuations prepared by management experts and evaluating whether disclosures in the financial statements achieve fair presentation.
In planning the audit, the auditor must focus on understanding the accounting and disclosure requirements and understanding the financial instruments to which the firm is exposed, and their purpose and risks. The auditor must determine whether specialized skills and knowledge are needed in the audit and also evaluate the system of internal control in light of the firm’s financial instrument transactions and the information systems that fall within the scope of the audit.
More specifically, the auditor must understand the nature, role and activities of the internal audit function and management’s process for valuing financial instruments, including whether management has used an expert or a service organization.
Determining materiality involves both quantitative and qualitative considerations. When planning the audit, materiality may be difficult to assess for a firm using particular financial instruments given some of their characteristics. In particular, some financial instruments can be assets or liabilities depending on their valuation and this may change over the course of the audit.
Under the guidance, a firm’s policies for accounting for financial instruments must take into account the different purposes for which they can be transacted, such as trading or hedging. Relevant accounting standards may be under review and firms need to monitor developments to ensure the correct accounting requirements, including possible transitional arrangements, are complied with. Having regard to disclosure requirements is important as they can play a key role in making transparent the levels of holdings of financial instruments, as well as their purpose and the underlying risk profile.
The FRC posits that it may be appropriate for the auditor’s understanding of relevant industry and regulatory factors to include inquiry of management as to whether there have been discussions with regulators during the year about their policies in respect of financial instruments, and whether management has reviewed its processes in the light of those discussions. For example the regulator may have expressed a view that the entity’s valuations appear out of line with those of other entities or are not sufficiently prudent. The auditor can review relevant correspondence, if any, with regulators.
For a regulated firm in the financial sector, it may be appropriate for the auditor to discuss matters related to the firm’s use and disclosure of financial instruments directly with the regulator in bilateral and/or trilateral meetings. In May 2011, the FSA published a Code of Practice for the relationship between the external auditor and the regulator. The Code of Practice sets out principles that establish, in the context of a particular regulated firm, the nature of the relationship between the regulator and the auditor.
While intended to mitigate risk, inappropriate hedge transactions can cause significant financial loss if the risks are not properly identified or managed. A simple example might be the hedging of baskets of bonds or shares with an index, if the basket does not match the index closely, price movements may not offset each other, therefore increasing risk not reducing it. Another example might be hedging of possible future price movements. For example, an airline that purchases all its future fuel needs for the next two years at forward prices, will suffer if the price then falls over the next two years, because unhedged competitors will benefit from a cost advantage.
Thus, auditing financial instruments may require the involvement of one or more experts or specialists, for example, in the areas of understanding the operating characteristics and risk profile of the industry in which the company operates and understanding the business rationale for the particular financial instruments used, the related risks and how they are managed. The involvement of experts or specialists may be needed especially when the financial instruments are complex or the firm is engaged in the active trading of complex financial instruments.