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.