,2 chapter

Auditingfatrvalues

lntroduction Topic List I 2 Fairvalue Financialinstruments

and Summary Self-test reference Technical Answersto Self-test questions to Answers Interactive

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Fair value
Section overview
) ) liabilities componensof equitymayarisefrom both the initial and of Fairvaluemeasurements assets, in and oftransactions laterchanges value recording ofthe fair the of both the assessment risk andevaluating appropriateness fair Auditing valuerequires value costs,share-based Fairvalueis i key issueto investmentproperty, peJrsion Payments

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lntroduction
willing Fair value is the amount for which an asset or liability could be exchangedbetween knowledgeable' length transaction. parties in an arm's important and affectsthe audit ofvaluation for both assetsand Fair value accountingis increasingly liabilities.Many standardsnow allow valuation at fair value.The following table summarisessome of the which you should be familiar with from your financialreporting studies. main instances

"
Plantond BAS l6 Property, Equipment Eenefts BAS l9 Employee ofAssets BAS36 lmPoirment

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plantandequipment modelan item of ProPercy, Underthe revaluation whosefair valuecanbe measured reliably is carriedat fair value less any subsequentdepreciation for When accounting a defined benefit plan the fair value of plan assetsshouldbe established
Recoverableamount is the higher of fair value less costs to sell and value in use

Instruments Fair valuesmay be used to measurecertain financial assets and BAS39 Finonciol and Recognition Meosurement liabilities ProPerty BAS40 lnvestment BAS4 | Agriculture
After initial recognition investmentProPerty may be measured at fair value

at A biological asset shouldbe measured its fair value less estimated point of sale costs at Agricultural produce shouldbe measured its fair value less the point of harvest estimated point of sale costs at

Poyment 2 BFRS Shore-bosed

Share-based Payment transactions should be measuredat fair value

betweenthe acquisition the of Combinotions calculation goodwitl reflects difference BFRS Eusiness 3 date fair value of the consideration given plus the non' controlling interest (which may be measured at fair value) and the acquisition date fair vatue of the identifiable assetsacquired and liabilitiesassumed
from As you can see above fair value measurementsof assets,liabilitiesand components of equity may arise the initiat recording oftransactions and later changes in value. Changesin fair value both For measurementsthat occur over time may be treated in different ways under different circumstances' as other example,the revaluationof an item of owner occupied ProPerty would be recorded comprehensiveincome and taken directly to equity, whilst the annualrestatement of an investment property will be reflected in profit or loss.

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Advanced Stage- Advanced Audit and Assurance For the auditor the use of fair valueswill raise a number of issues. The determination of fair value will generallybe more dif{icult than determining historical cost. lt will be more difficult ro establishwhether fair value is reasonablefor complex assetsand liabilitiesthan for more straightforward assetsor liabilities which havean activelytraded market and therefore a market value. Generallyspeaking, the trend towards fair value accountingwill increaseaudit work required, not only because determiningfair valuesis more difficult, but becausefair values fluctuate in a way that historical costs do not, and will need vouching each audit period. Fair value will, for the same reasons,increase audit risk. Fair value is the subject of an auditingstandard,BSA 545 Audit)ng Volue Foir rl4eosurements Disc/osures. ond This addresses audit considerations relating to the measurement,presentationand disclosureof material assets,liabilitiesand specificcomponents of equity presentedor disclosedat fair value in financial statements.The standard requires auditors to obtain sufiicient appropriate audit evidence that fair value measurementsand disclosuresare in accordancewith the entity's applicable financialreporting framework. This meansthatthe auditor must have a sound knowledge of the accounting requirements relevantto the entity and when fair value is allowed.
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1.2 Auditing fair value measurements and disclosures 1.2.1 Risk assessmenr
Management is responsiblefor establishing the processfor determiningfair values.This processwill vary considerably from organisationto organisation. Some companieswill habituallyvalue items at historical cost where possible,and may have poor processes for determiningfair valuesif required. Others may have complex systemsfor determining fair value if they havea large number of assetsand liabilitieswhich they account for at fair value, particularlywhere a high degree of estimation is involved. BSA 545 requires the auditor to assess the entiq/s process for determining fair value measurements and disclosures and the related control activitiesand to assess the risks of material misstatement. This would include consideration of the following: ) The relevant controt activities over the processe.g.controls over data and the segregation duties of between those committing the entity to the underlyingtransaction and those responsiblefor undertakingthe valuations. The expertise and experience of those persons determiningthe fair value measurements The role that information technology has in the process

) ) )

The types and accounts or transactions requiring fair value measurementsor disclosures e.g. whether the accountsarise from routine/recurring transactionsor non-routine/unusual transactions The extent to which the process relies on a service organisation The extent to which the entity usesthe work of experts in determiningfair value measurements and disclosures The significant manatement assumptions used

) )

) ) )

Documentationsupponingmanatement'sassumptions The methods used to develop and apply manatementassumptionsand to monitor changes those in assumptions The integrity of change controts and security procedures for valuation models and relevant information systems,includingapproval processes Controls overthe consistency, timeliness and reliabilityof the data usedin valuation models

1.2.2 Evaluating appropriareness fair value the of

BSA 545 requires the auditor to evaluatewhether the fair value measurementsand disclosuresin the financialstatementsare in accordance with the entifs applicable financiat reporting framework.

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Where these measurementsare basedon assumptionsabout future conditions,transactionsor events resultingfrom managementintentions to carry out certain actions the auditor should: ) Consider management's liabilides Review written past history of carrying out its stated intentions with respect to assetsor

) ) )

plans and other documentation,

includingwhere applicable,budgets minutes etc

Consider management's

stated reasons for choosinga parcicularcourse of action

Consider management's ability to carry out a particular course of action given the entity's includingthe implicationsof its contractual commitments. economic circumstances,

lf there are alternativeallowable methods for measuringfair value, or a particular model is not prescribed by the relevant accountingstandard,the auditor should consider whether the entity's method is consistent with other fair value measurementsin the financialstatementsand whether it is applied consistently.

in to | .2.3 Audit procedures response riskassessment

BSA 545 staresthat the auditor should perform further audit procedures designedto address the risk of misstatement. The nature, timing and extent of further audit procedures will depend heavilyon the complexity of the fair value measurement.For example,the fair value measurementof assetsthat are sold in open, active actually and reliable information on the prices at which exchanges markets that provide readily available occur should be relativelystraightforward e.g. publishedprice quotations for marketablesecurities. that make it Alternatively, a specificasset may not have an active market or may possesscharacteristics for to necessary management estimate its fair value e.g.an investment property or a complex derivative financialinstrumenr.The estimation of fair value may be achievedthrough the use of a valuation model (for example,a model premised on projections and discountingof future cashflows, or an oPtion Pricing of model) or through the assistance an expert such as an independentexpert (e.9.to value propeny, brands or other specialistassets). Complex fair vatue measurements normally are characterisedby greater uncertainty reliabilityof the measurementprocess.This greater uncertainty may be the result of: ) ) ) ) Length ofthe forecast period with the Process The number of significant and complex assumptions associated and fuctors used in the process with the assumptions A higher degree of subjectivity associated with the future occurrence or outcome of events A higher degree of uncertainty associated underlyingthe assumptionsused regardingthe

whether: When obtainingaudit evidencethe auditor evaluates ) ) ) The assumptions used by manasementare reasonable The fair value measurementwas determined usingan appropriate model if applicable at Managementused relevant information that was reasonablyavailable the time

Other actions by the auditor would also include the following: ) The auditor should consider the effect of subsequent events on the fuir value measurementsand disclosuresin the financialstatements The auditor should evaluatewhether the disclosures about fair values made by the entity are in accordancewith its financialrePorting framework The auditor should obtain written representationsfrom management

1.2.4 Currentdevelopments Estrmotes, Auditing Accounting and ISA has 5 As we sawin Chapter the IAASB issued 540(Revised Redrafted) I (see aspart Disclosures of the ClarityProiect Chapter ). ondReloted Btimotet Accounting Foir lncluding Volue

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Advanced Stage- Advanced Audit and Assurance This standard combines two former standards, ISA 540 Audit of Accounting &trrnotes and ISA 545 AuditingFoir ValueMeosurements Disc/osures. new ISA treats fair valuesas a type of accountingestimate and ond The therefore the requirements of the ISA listed in Chapter 5 (section 7.5) apply as they would to any other type of accountingestimate.

1.3 Application
This section looks at the audit of a number of areaswhere fair value is a key issue.Note that whilst the audit of fair value is important audit procedures also need to addressother aspectstoo, for example completeness, ownership,disclosure and so on.

| .3.1 Investment property Definition

InYestment proPerty: Property(landor a building- or part of a building- or both) held(by the owner or by the lessee undera finance lease) earnrentals for capital to or appreciation both,ratherthanfor: or ) ) Usein the production supply goodsor seryices for administrative or of or purposes; or Sale the ordinarycourseof business. in

The following would be non-investmentproperties: ) ) ) ) Property held for sale in the ordinary course of business Property being constructed or developedon behalfof third parties Owner occupied propemy Property being constructed or developedfor future use as investment propeny

InvestmentProPerty is initially measuredat its cost. After recognition it is either measuredat cost or fair value. Audit evidence
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Classificationas an investment property

Confirm that all investmentproperties are classified in accordancewith BAS 40 definition.This will include: ) A buildingowned by the entity and leasedout under one or more oPeratingleases A buildingthat is vacant but is held to be leasedunder one or more oPeratingleases

Verify rental agreements,ensuringthat the occupier is not a connected company and that the rent has been negotiatedat arm's length lfthe buildinghas recently been built, check the architect's certificatesto ensure that construction work has been completed.

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Valuation

lf cost model adopted check compliancewith BAS l6 lf fair value model adopted: ) Check that fair value reflects market conditions at the end of the reporting period Agree valuationto valuer's certificate Where current prices in an active market are not available confirm that alternativevaluation basisis reasonableand in accordancewith BAS 40 gain or loss on changein fair value and agreeto Recalculate income amount in statementof comprehensive lf fair value cannot be measuredreliably confirm use of cost model

) )

Disclosure

Confirm compliancewith BAS 40, for example: ) ) Disclosure of policy adopted lf fair value model adooted disclosureof a reconciliation of carrying amounts of investment property at the beginning and end ofthe period.

pt''op*rty and {air valals Nnteractive qu*$tien {: Invesca'xlstjf l3if*cuitvi*vel: {*terrn*dia(el

Propertyco Ltd, an investment property company,has a portfolio of properties includingthe following:

Property A Property B Property C Property D

This is used as the company head office This is held under a financeleaseand is currently rented out to a nongroup companyunder an operatjng lease This was acquired in the year at a cost of CU3m includinglegalfees' lt is currently vacant but a tenant is being activelysought This has been owned by Propertyco Ltd for a number ofyears and is currently rented out to a non-grouP comPany

Propertyco Ltd wishes to adopt the fairvalue model in accordancewith BAS 40. Currently all of the above properties are recorded in the financialstatementsat fair value. Basedon the information above: (a) (b) ldentify the audit issueswhich the auditor would need to consider List the audit procedures you would perform regardingfair values

SeeAnswer at the end of this chapter.

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1.3.2 Pension costs

The treatment of a defined contribution scheme is relativelystraightforward.

BAS l9 Employee Benef;ts requires the following. (") Contributions to a defined contribution plan should be recognisedas an expense in the period they are payable(except to the extent that labour costs may be includedwithin the cost of assets). Any liabilityfor unpaid contributions that are due as at the end of the period should be recognisedas a liability(accruedexpense). Any excesscontributions paid should be recognisedas an asset (prepaidexpense),but only to the extent that the prepayment will lead to, e.g.a reduction in future paymentsor a cash refund. Disclosure is required of a description of the plan and the amount recognisedas an expense in the period.

(b)

(c)

(d)

Accounting for defined benefit plansis much more complex. An outline of the method used for an employer to account for the expensesand obligation of a defined benefit plan is given below.

$tep I
Actuarial assumPtions should be used to make a reliable estimate of the amount of future benefits employeeshave earned from service in relation to the current and prior years.Assumptions include,for example,employeeturnover, mortality rates,future increasesin salaries(if these will affect the eventual size of future benefitssuch as pension payments).

$tep ?
These future benefitsshould be attributed to service performed by employeesin the current period, and in prior periods.This givesa total present value of future benefit obligationsarisingfrom past and current periods of service.

S**p 3
The fair value of any plan assetsshould be established.

${*p 4
The size of any actuarialgainsor lossesshould be determined,and the amount of these that will be recognised.

$t*p S
lf the benefits payable underthe planhavebeenimproved, extra costarising the from pastservice should be determined. $e*p * lfthe benefits payable underthe planhavebeenreduced cancelled, resultinggain or the shouldbe determined You shouldreferto your corporatereporting text if you requirefurtherrevision the accounting of treatmentof pensions.

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Audit evidence

Scheme assets (including quoted and unquoted securities,debt instruments, ProPerties)

Ask directors to reconcile the scheme assetsvaluation ai the schemeyear end date with the assetsvaluation at the reporting entity's date being used for BAS l9 PurPoses investmentcustodian

) Scheme liabilities )

Consider requiring schemeauditors to perform procedures Auditors must follow the principlesof BSA 623 lJsingthe Work whether it is appropriate to rely on the of on Expertto assess actuary'swork Specificmatters would include The source data used and methods used The assumptions The results of actuaries'work in the light of auditors' knowledge of the businessand results of other audit procedures

Actuarial source data is likely to include: ) ) Schememember data (for example,classesof member and contribution details) Schemeassetinformation (for example,values and income and expenditure items)

Actuarial assumptions (for example,mortality rates, termination rates, retirement in age and changes salary and benefit levels)

Auditors will not havethe same expertise as actuariesand are the appropriatenessand unlikelyto be able to challenge They should nevertheless reasonableness the assumptions. of and experience of the actuaries.Auditors ascertainthe qualifications with directors and actuaries: can, also,through discussion ) ) ) ofthe assumptionsand review Obtain a generai understanding the process used to develoPthem with those which directors have used Compare the assumptions in prior years Consider whether, basedon their knowledge of the rePorting entity and the scheme,and on the results of other audit apPearto be reasonableand procedures,the assumptions compatiblewith those used elsewhere in the PreParationof the entity's financialstatements ) Obtain written representations from directors confirming are consistentwith their knowledge of the that the assumptions business

) Items charged to operating profit (current cost, cost,pastservice service gains losses on and and settlements curtailments)

current the andactuaries factorsaffecting Discuss with directors may closedto new entrants a cost (for example, scheme service of yearon yearasa PercentaSe paywith the seean increase age average of the workforceincreasing)

additional andactuaries', with work are inconsistent the directors' of Where the results auditors' in mayassist resolving from anotheractuary, directors obtainevidence to procedures, as requesting such the inconsistency.

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1.3.3 Share-based payments

BFRS Shore-bosed 2 Poyments requires entities to recognisethe goods or servicesreceived as a result of share-based payment transactions. There are three types of share-based payment transactions. (t) Equity-settled share-based payment transactions, in which the entity receivesgoods or services in exchangefor equity instruments of the entity. Cash-settled share'based payment transactions, in which the entity receivesgoods or services in exchangefor amounts of cashthat are basedon the price (or value) of the entity's sharesor other equity instruments of the entity. Transactionsin which the entlty receivesor acquiresgoods or servicesand either the entiry or the supplier has a choice as to whether the entity settles the transaction in cash (or other assets)or by issuing equity instruments.

(b)

(c)

An entity should recognisegoods or servicesreceived or acquired in a share-based payment transaction when it obtains the goods or as the servicesare received.They should be recognisedas expensesunless they qualifyfor recognition as assets. Transactionsare measuredat fair value. Audit evidence

Number of employeesestimatedto benefit

) )

Enquireof directors Compare to staffingnumbers per forecasts and prediction For equity-settledschemescheck that fair value is estimatedat the grant date For cash-settled schemescheck that the fair value is recalculatedat the end of the reporting period and at the.date ofsettlement
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Fair value of instruments

Check that the model used to estimate fair value is in line with BFRS2 and is appropriate to the conditions.Consider obtainingexpen adviceon the valuation if appropriate.

General

Obtainrepresentations management from confirming their viewthat The assumptions in measuring used the expense reasonable, are and Thereare no share-based payment schemes existence havenot been in that disclosed the auditors. to

(Alsoseechapter l3 of this StudyManual auditof remuneration for packages).

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20X5 3 for statements the yearending | December Ltd. You arethe auditorof Russell The draftfinancial four of its directorseachwith 3,000share Ltd Russell provided showa profit beforetax of CU400,000. by 20X7.The fair valueof the options,determined 20X5 whichveston 3l December optionson I January Black-Scholes model,is asfollows: useof the CU l0 CU 12 CU 15 CU l3 At the grantdate 20X6 On I January 20X7 On I January 20X7 On 3 | December

No to All employment. four directorsare expected remain. entry on The optionsare dependent continued that they do Ltd of statements Russell in respect the optionson the basis of hasbeenmadein the financial 20X7. not vestuntil 3 | December Requirement in of you auditissues would needto consider respect the shareoPtions. ldentifythe Answer at the end of this chapter. See

2 Financialinstruments

2.1 Introduction
ln recent years there has been huge growth in the number and complexity of financialinstruments available for investmentor issue by companies.This raisesboth accountingand auditing issues.

Definition
Financial instrument: Any contract that gives rise to a financialasset of one entity and a financialliability or equity instrument of another entity.

fall This definition is very broad which meansthat many common balances within its scope including:

Cash and Tradepayables receivables payable receivable and Loans

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Advanced Stage- Advanced Audit and Assurance The definitionalso incorporatesmore complex instruments example: for ) ) ) ) ) Debt and equity investments Derivatives(e.g.interest rate swaps and foreign exchangecontracts) Redeemable and irredeemablepreference shares Convertible debt instruments Investmentsin sharesissuedby other entities

The relevant accountingstandardsfor financialinstrumentsare: BAS 32 Fin nci lnsrruments.' o ol Presentotion BAS 39 Finonciollnstruments.. Recognition ond Measurement BFRS7 Finonciollnsrruments: Disclosures You should be familiarwith these from your corporate reportint studies.A brief summary of the key points is provided below.

2.2

Summary of accounting treatment

) A financialinstrument should be classified as:

Afinancial asset A financial liability An equity instrument

in accordance the substance with ofthe contractunderwhichit hasbeenissued. )

)

A compound instrument (e.g. convertible a bond)shouldbe splitinto its component partsat the
date it is issued. Financial assetsare recognisedinitially at their fair value.

The rules for subsequentmeasurementare:

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Fair (changes value '"..tii'"J ii ;.;il;;i;;i

Amortised cost using effective interest method Amortised cost usingeffective interest method Fair value (changes recognisedin other comprehensive income until disposal)

Held to maturity investments Loan and receivables Available-for-sale nancialassets fi

Disclosuresmust be made which enablethe readersto evaluate: The significance financialinstruments for the entity's financialposition, and performance of The nature and the extent of risk arisingfrom financialinstrumentsto which the entity is exposed during the period and at the reporting date, and how the entity manages those risks.

2.3 Audit issues

2.3.1 Risk
Financial instruments, complex ones,increase audit risk. Factors which increase include Particularly risk the following: ) ) Lack of management understanding of financiat instruments thereforeinadequate and management control Inappropriate classificationof financial instruments, particularly between debtandequitymay leadto off-balance sheetfinancing. will affect This gearing therefore risk profile of the and the business. is particularly issue This an where hybridor compound instruments havebeenissued where there are both debtandequityelements.

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) the Complexity of the accounting requirements of BAS 32 and 39. This increases risk of error. as For example financialassetsand liabilitiesmust be classified fallingwithin one of four categories. This categorisationdetermines their subsequentmeasurement(amortised cost or fair value).Incorrect may have a significantimPact on the financialstatements classification ) Determining fair values involvesthe use of valuation techniques includingmarket estimates. ludgements will need to be made to determine whether the valuationtechniquesand any estimates made are reasonable.(See section I above) straightforward. For Recognition of the costs associated with the instrument is not necessarily part of the overall cost of the example the discount on a discounted debenture should be treated as instrument and recognisedover the life ofthe debenture.

2.3.2 Audit procedures

the instrument, nature the financial of depend the specific on soughtwill and the Although issues evidence apply: will key following considerations normally _" " ' -' : ._ : _ Classification - ^ . . and instrument confirmthat they havebeen the Review terms ofthe financial
Where the company has designated in classified accordancewith their substance. financialinstruments to be treated at fair value through profit or loss there needs to be evidencethat the required conditions accordingto BAS 39 have been (e.g.that there is an accountingmismatch) satisfiedat the date of designation. (see Financial and Corporate Reporting text for detailsof conditions for AFWPL Confirm that all financialassetsand liabilitieshave been valued at fair value Agree fair value to transaction price Where part of the considerationhas been given for something other than the valuationtechnique adopted, e.g. discountingof future financialinstrument assess cash flows Consiler the impal o,f_tranTctio: costs where alProPriate

Valuation: Initial fair value

Valuation: Subsequent measurement

of Verify the subsequentclassification financialinstruments by enquiry of as management, to their intention to sell in the short-term, or hold to maturity. This information should be corroborated by a review of events after the end of the reporting period and offorecasts and proiections. Confirm that held to maturity investmentsand loans and receivablesare measuredat amortised cost. Check calculationof amortised cost complieswith BAS 39: ) ) ) The initial amount recognisedfor the financialasset Lessany repaymentsofthe principalsum Plus any amortisation

Confirm that the amount of amortisation has been calculatedusingthe effective interest method. Confirm that financialassetsand liabilitiesat fair value through profit or loss and financialassetsare remeasuredat hir value available-for-sale Where there is an active market agreefair value to quoted market price (current bid price) the valuationtechnique adopted by Where there is no active market assess made and any assumPtions management (For funher detail regardingthe audit offair valuessee section I above).

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*rz r z*xi"r* q * e st i c n 3: * * nv *r *ibl * 4*b *nt:u r a t*

{Witzrulty l*v e2:{.x*'m staxdard}

On I January 20X8 BerrimanLtd issueda CUl0 milliondebentureat par. The debenturehasa nominalrate of interest of 4%and is redeemableon I January20Y3. On this date the holder has the option to converr the debenture to 6 million CU I ordinary sharesin Berriman Ltd. The financialstatementscurrently show a long-term liabilitywhich representsthe net proceeds of the debenture.The first payment of interest on 3 | December 20X8 has also been recorded. Requirements (i) (ii) ldentif the issues surrounding this debenture List the audit procedures you would perform

SeeAnswer at the end of this chapter.

2.4 Derivatives
Definition
A derivative: is a financialinstrument or other contract within the scope of BAS 39 with all three of the following characteristics: ) lts value changesin responseto the changein a specifiedinterest rate, financialinstrument price, commodity price, foreign exchangerate, index of prices or rates, credit rating or credit index, or other variable'provided in the caseof a non-financial variablethat the variableis not specificto the pafty to the contract (sometimescalledthe 'underlying,) lt requires no initial net investmentor an initial net investmentthat is smallerthan would be required for other types of contracts that would be expectedto havea similar responseto changesin market factors; and lt is settled at a future date.

Derivativesinclude swaps, options, swaptions, forwards, and futures. BAS 39 requires that derivativesbe measuredat fair value in the statement of financialposition unlessthey are linked to, and must be settled by, an investment in an unquoted equity instrument that cannot be reliably measured at fair value' In such casesthe derivativewould be measuredat cost instead,which, in many cases, would be close to zero. In generalentities use derivativesto either speculate or ofrset risk (hedge). When changesin fair value occur these can be recognisedeither in profit or loss,or in equity,As a general rule changei in fair value of a derivativeare recognisedin profit or loss. However, when the derivativeis used to offset risk and soecial hedgeaccountingconditions are met, at least some changes fair value may, optionally, in be recognisedas a separatecomponent of equity. This is hedge accountingunder BAS 39. Entitiesmust properly identify derivatives per the criteria given in the definition above. Derivativesare becominga common way for companiesto manage financialrisk. For many entities,the use of derivativeshas reduced exPosure to changesin exchangerates, interest rates and commodity prices as well as other risks. However the inherent characteristics derivativesmay also result in of increasedbusiness risk in turn increasing audit risk and presentingnew challenges the rrditor. to For example valuesof derivativesmay be volatile. Largeand sudden decreasesin their value may increase the risk of a loss arising exceedingthe amount, if any, recorded in the statement of financialposition. ln addition, becauseof the complexity of derivativeactivities,manatement may not fully understandthe risks of using derivatives. While all financialinstruments have certain risks as we have seen above,derivatives often have particular featureswhich leveragerisk includingthe following

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) ) ) ) Little or no cash outflows/inflows are,required until maturity of the transactions

No principal balance or other fixed amount is paid or received greater than the current outlays Potential risks and rewards can be substantially The value of an entig/s asset or liability may exceed the amount, if any, of the derivativethat is recognised in the financial statements

lnstrumenrprovidesguidanceinthisareaandissummarisedbelow. BAPSl0l2AuditingDerivativeFinanciol Many of the issueswhich it raisescould equallyapply to other types of financialinstrument.

financial instruments 2.4.1 Auditingderivative

the same as would apply to any other The basicprinciplesinvolved in the audit of derivativesare essentially evidenceis sought and so on. BAPS | 0 I 2 provides guidanceon how these transactioni.e. risk is assessed, nature of the derivative. principlesare adaptedto deal with the specialised Need for special skill and knowledge Whilst the potential complexity of derivativesmay raise issuesfor managementthe auditor also needs to the knowledge and skills required to perform the audit of derivatives. assess whether he possesses Ethical guidance requires that the professionalaccountantperform professionalserviceswith competence and diligence. lt further requires that the auditor maintainssufficientprofessional with due care. As a result specialskill and knowledge may be knowledgeand skill to fulfil responsibilities required includingan understandingof: ) ) ) The operating characteristics and risk profile of the industry in which the entity operates used by the entity, and their characteristics

The derivative financial instruments The entity's information organisation

system for derivatives,includingservicesprovided by a service

The method of valuation of the derivative,for example whether fair value is determined by quoted market price, or pricing model The requirements of the financialreporting framework for financialstatement assertionsrelated to derivatives

Knowledge of the business the need for the auditor to obtain an understanding of the factors which affect BAPS | 0 | 2 recognises ofthe effects the entity's derivative actiyities. In particular the auditor should obtain an understanding of the following:

General economic -factors

Factorsthat may be relevant include: * t'he general level of economic activity of Interest rates (includingthe term structure of interest rates, and availability financing) Inflation and currency revaluation Foreign currency rates and controls of The characteristics the markets that are relevant to the derivativesused by the entity, includingthe liquidity or volatility of those markets

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The industry

E;;;omic";;?fio;iffi
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The price risk in the industry The market and competition Cyclical or seasonalacrivity Declining expanding or operations Adverse conditions (for example,decliningdemand,excesscapacity,serious price competition) Foreign currency transactions,translation or economic exposure

The entity

The auditor considers: Knowledge and experience of management and those chargedwith governance Availabilityof timely and reliable management information (control risk may increasewith greater decentralisation these activities) of objectives for the use of derivatives(risk increases where maximisationof profits is the objective)

Key financial risks The auditor should also obtain an understandingofthe principaltypes offinancial risk related to the derivativeactivities.Key financialrisks include: ) Market risk This relatesto economic lossesdue to adversechanges the fair value of the derivative in ) Credit risk The risk that a customer or counterpany will not settle an obligationfor full value ) Settlement risk

The related risk that one side of the transactionwill be settled without value being received from the customer or counterParty ) Solvency risk The risk that the entity would not havethe funds available honour cashoutflow commitments as to they fall due
t

Legal risk This relatesto lossesresultingfrom a legalor regulatory action

Risk assessment and internal control BAPS l0l2 also recognisesthe need to comply with the BSA 315 Obtaining LJnderstondingof Eniltyond on the its Enironment ond Assessrng Risk of Materiol Misstotementrequirement to assessrisk and design audit the proceduresto ensure that risk is reduced to an acceptablylow level. In addition an understandingofthe accountingand internal control system must be obtained to enablethe auditor to assess whether it is adequateto deal with the type of derivativetransactionscarried out by the entity. For example,the more complex the instruments the more sophisticatedthe systemswould need to be to deal with them. The BAPSalso emphasises the need for a strong control environment objectives.Control objectives would include the following supported by clear control

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" Authoii;;ti-;xecutiori Oerivaiivetiinsactions are executed in iccordinie wittr ttre entity;s approvedpolicies Information relatingto derivatives,includingfair value rnformation,is recorded on a timely basis,is complete and accurate when entered into the accountingsystem,and has been properly classified, described and disclosed informationfor of in Misstatements the processing accounting derivativesare prevented and detected in a timely manner io derivatives are monitored on an ongoingbasis Activitiesinvolving recogniseand measure events affectingrelated financialstatement assertions Changesin the value of derivativesare appropriately accountedfor and disclosedto the right people from both an oPerationaland a control viewpoint. Valuation may be part of ongoing activities

Complete and accurate information

Prevention or detection of errors Ongoing monitoring

Valuation

In addition for derivatives designed as hedges, internal controls should assurethat those derivatives and on an ongoingbasis. accounting, both atthe inceptionof the hedge, meetthe criteriaforhedge Control procedures One of the most important control procedures identified by BAPS | 0 | 2 is the reconciliation. lt identifies the following as being particularly relevant: ) Reconciliationof dealers' records to records used for the ongoing monitoring process and the position and profit or loss shown in the generalledger to Reconciliationof subsidiaryledgers,includingthose maintainedon computerised databases the general ledger Reconciliationof all clearingand bank accountsand broker statementsto ensure all outstandingitems are promptly identified and cleared where Reconciliationof entity's accountingrecords to records maintainedby service organisations, applicable

Tests of controls Examplesof tests of controls to consider include: ) Readingminutes of meetingsof those chargedwith governancefor evidencethat there is a periodic review of derivative activitiesand hedgingeffectiveness Test transactionsto determine whether the entity has obtained required approvalsfor the transactionsand used only authorised brokers Discusswith managementwhether derivativesand related transactionsare being monitored and reported on a timely basisand read any supporting documentation and prices,and the entries usedto Test recorded purchasesof derivatives,includingtheir classification record related amounts that have a large number of derivative Test the reconciliation process.For example,organisations transactionsmay require reconciliationand review on a daily basis Test the controls for unrecorded transactionse.g.examine third party confirmations Test the controls over the adequatesecurity and back-up of data to ensure adequaterecovery in the caseof disaster.

) )

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Advanced Stage- Advanced Audit and Assurance Substantive procedures BAPS | 0 I 2 statesthat substantiveprocedures should be performed in accordancewith the principlesof BSA 3 15.Specificexamplesof procedures in respect of key assertionsare given as follows: '*-"^-- --eonfffiaiffi Eiisi;;;e-inJ ociurreni;w'rththe Filaei oflcounterparry'to the derivative Inspectionof underlyingagreementsand other forms of supportingdocumentation Inspecting supporting documentation for subsequentrealisation or settlement after the end of the reporting period Inquiry and observation

Rights and obligations

Confirming iignificantteims with the holder of, or counterparty to, the derivative lnspectingunderlyingagreementsand other forms ofsupporting documentation

Completeness

Alking the holder oflcounterparry to the derivativeto provide detailsof all derivativesand transactionswith the entity Sending zero-balance confirmations to potential holders/cou nterparties Reviewingbrokers' statemen$ Reviewingunresolvedreconciliationitems Inspecting atreements such as loan or equity agreementsfor embedded derivatives

Viiuation cnd ;eiiuiamena

Inspecting documentationfor activity subsequentto the year end

ftp;aai;gdocumeniition evidence thepuiihile priie with of

Confirming with the holder of/counterpafty to the derivative Reviewing the creditworthinessof counterparties to the derivativetransaction Obtaining evidencecorroborating the fair value of derivatives measuredor disclosedat fair value (in accordancewith BSA 545). This may include: ) Assessing the reasonableness appropriateness and ofthe model Calculating the value, usinga model developed by the auditor or by a specialistengagedby the auditor Comparingthe hir value with recent transactions Consideringthe sensitivityof the valuationto changes in the variablesand assumptions Review of eventsafter the end of the reporting period which may provide evidenceabout valuationat the period end

) )

Pr;;tatio;

ilA-disCGsure-**"-*ehbckfomptiance;itii re6vant reportfitil;ArAs 'r. EASn;

BAS39, BFRS 7

Management representations The extent to which rePresentations will be sought will depend on the volume and complexity of derivative activities.

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in financial instruments the modern world 2.4.2 Auditingderivative
The key to using derivativesas part ofan overall investment strategy is to have adequate internal controis in place and trained personnethandlingthe investments.Derivatives,which have been around for a very long time in one form or another, have been put to good use by transferring risk from one party, the hedger,to another, the speculator.There are many factors in today's world which can causederivative investment strategiesto go wrong. As we have seen such factors will include: ) ) ) ) ) A lack of internal controls management A laissez-faire Greed Ineffectivesystemsto identify and monitor risk Inexperience

An understandingofthe businessprocess involved in derivativestrading is necessaryin order to audit The steps in a typical such process are: derivativessuccessfully. I 2 3 4 \ 5 6 7 8 Enteringthe deal in the trader's deal sheet Trader types the deal into the system and sends an e-mail The back office include the deal into reports Back office process the deal usingmarket quote information from agencies Enter details into a'pre-programmed' Excel sheet and/or other processingpackage Confirm deal with brokers/counterparties Carry out monthly settlement/processing Net off between accounts payableand accounts receivableand wire the payment as necessary

Eachtype of derivativewill be different and non-standardderivativeswill be unique. This poses challenges for the auditor. Generally,however, the auditor should seek to: ) Understand the client's business in order to establishthe real role played by, and the risk that are inherent in, the derivativesactivity Document the system. This would involve documentingvarious processes

) )

ldentify the controls in each processin order to establishthe risk passedto the client by inadequateor missingcontrols; and therefore, to establishthe audit risk and thus the audit work that needsto be performed Carry out the appropriate control and substantive audit procedures

) )

Make conclusions and report on the outcome of the audit of derivatives

of Obviously the exact nature of what is to be done is dependent on the circumstances the client. Ensuring that the information has been captured completely and accurately in each case is important.

Worked

sxarnple: $ystenrs an{* prc{ssse$

refineit, sources, in company one countrywill obtainoil from different Typically largeoil refining a products its customers. petroleum for producing various will takeforwardpositions The traders in in is lmagine company involved trading crudeoil Futures. the at available the time. lf the traders oil pricemovement relating future to with strategically the information it forward)andif they exPect to (buythe commodity priceto rise,they will takea LongPosition expectthe forward). (sell commodity the fallthey will take a Short Position with this. for that ldentify key processes the auditorwouldseekevidence in connection the

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A d v a n c e dS t a g e A d v a n c e dA u d i t a n d A s s u r a n c e **|t-tti*rt Capture of information: the primary source document is the trader's deal sheet. This document should contain the date, time, the oil index, guantitytraded, the position (Long or Short), nature oftrade (Hedge or Speculation) and the rationale for the trade. Processing of information: sheet. the back office report should contain the same information as in the deal

Confirmation of information: There should be a statement from the clearingagents(sincethese are Futures)confirming the details. [Note that Swapstransactionswould be confirmeJdifferently, via Counterparty and Broker confirmations and that Options are confirmed in the same way that futures are]. Depositing of margin money: There should be evidencethat margin money had been deposited with the exchangeas required (in casethe Mark to Market crossesthe exchange's threshold limits). Settlement: There will be clearingstatementsfrom clearingagents.These should be used in collaboration with internallygenerated information to confirm that the appropriate settlement amounts exchanged hands. Accounting: The deals have been accountedfor correctly. In all these Processes controls will havebeen implemented and the auditor should identifi these and assess their utility.

Xnt*ra{tive qil*:stie:n4: *}*ri:sativ**

You are the auditor in charge of the audit ofJohannesLtd.

f*if$cuFty levell SNar* standaregj

On I January20X7, JohannesLtd ("J"), entered into a forward contract to purchaseon I January20X9, 40,000 barrels of crude oil at $70 per barrel.J is not usingthis as a hedginginstrument and is speculating that the price of oil will rise and plansto net setde the contract if the p;ic; rises. does not pay anythingro J enter into this forward contract. At 3 | December 2OX7the fair value of the forward contract ias increased to CU500'000. At the end of 20X8, the fair value of the forward contract has declined to CU400.000. Requirement (") ldenti! the accountingentries you would expect to see at the inception ofthe contract, at 3 | December 20X7, and at 3 | December 20Xg ldentif the risks you would expect to find in this arrangement,and the audit procedures that you would carry out Outline the stePsthat you would take to ensure compliancewith BFRS7 Finonciol/nstrurnents.. Disclosures

(b)

(t)

SeeAnswer at the end of this chapter.

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Summary

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