The U.K.’s oversight authority for accounting and auditing issued updated guidance for the outside financial audits of entities of all sizes that may be subject to the risks associated with using financial instruments. The Financial Reporting Council said that the guidance is designed to enhance investor confidence in the depth and reliability of the audit of financial statements. Nick Land, FRC Chair of the Audit and Assurance Council, noted that financial instruments is an area of financial reporting involving complex issues, which came under particular focus in the financial crisis. The updated guidance is intended to assist auditors in understanding the nature of, and risks associated with, financial instruments, the different valuation techniques and types of controls that may be used by entities in relation to them, and identifies the important audit considerations.
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 (the latter involving representatives of the regulated firm. Here, the FCA referenced its July 2013 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.
It may be appropriate for the auditor’s understanding of relevant industry and regulatory factors in accordance with ISA 315 to include inquiry of management as to whether there have been discussions with regulators during the year about its policies in respect of financial instruments, and whether management has reviewed its processes in the light of those discussions, for example if the regulator has expressed a view that the firm’s valuations appear out of line with those of other firms or are not sufficiently prudent. The auditor should review any relevant correspondence with regulators.
The FRC guidance also noted that the application of professional skepticism is required in all circumstances and the need for professional skepticism increases with the complexity of financial instruments, for example with regard to evaluating whether sufficient appropriate audit evidence has been obtained. Thus can be particularly challenging when models are used in determining the fair value of a financial instrument or in determining if markets are inactive.
There should also be heightened professional skepticism when the auditor evaluates management 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. Professional skepticism also comes into play when drawing conclusions based on the audit evidence obtained, for example assessing the reasonableness of valuations prepared by management’s experts and evaluating whether disclosures in the financial statements achieve fair presentation.
In any event, continued the guidance, evaluating audit evidence for assertions about some 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 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. Accordingly, 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
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, hedging or investment. Relevant accounting standards may be under review and entities 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 the levels of holdings of financial instruments, their purpose and the underlying risk profile transparent
A key consideration in audits involving financial instruments, particularly complex financial instruments, is the competence of the auditor. International audit standards require the audit engagement partner to be satisfied that the engagement team, and any auditor’s experts who are not part of the engagement team, collectively have the appropriate competence and capabilities to perform the audit engagement in accordance with professional standards and applicable legal and regulatory requirements and to enable an auditor’s report that is appropriate in the circumstances to be issued.
Use of Experts. The guidance recognizes that auditing financial instruments may require the involvement of one or more experts or specialists to assist in understanding the operating characteristics and risk profile of the industry in which the company operates and in understanding the business rationale for the particular financial instruments used by the firm, the related risks and how they are managed.