Understanding the Financial Instruments---AICPA BOOK EXCERPTS
2.06 The characteristics of financial instruments may obscure certain elements of risk and exposure. Obtaining an understanding of the instruments in which the entity has invested or to which it is exposed, including the characteristics of the instruments, helps the auditor identify whether:
2.06 The characteristics of financial instruments may obscure certain elements of risk and exposure. Obtaining an understanding of the instruments in which the entity has invested or to which it is exposed, including the characteristics of the instruments, helps the auditor identify whether:
- Important aspects of a transaction are missing or inaccurately re-corded.
- A valuation appears appropriate.
- The risks inherent in them are fully understood and managed by the entity.
- The financial instruments are appropriately classified into current and noncurrent assets and liabilities.
2.07 Examples of matters that the auditor may consider when obtaining an understanding of the entity's financial instruments include:
- The types of financial instruments to which the entity is exposed.
- The purpose for which they are used.
- Management's and, when 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, when transactions are linked, the overall effect of the financial instrument transactions.
- How they fit into the entity's overall risk management strategy. Inquiries of the internal audit function and risk management function, if such functions exist, and discussions with those charged with governance may assist the auditor in obtaining this understanding.
2.08 In some cases, a contract, including a contract for a nonfinancial instrument, may contain a derivative. Some financial reporting frameworks permit or require such embedded derivatives to be separated from the host contract in some circumstances. Understanding management's process for identifying and accounting for embedded derivatives will assist the auditor in understanding the risks to which the entity is exposed.
Understanding Internal Control
3.01 AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards), establishes requirements for the auditor to understand the entity and its environment, including its internal control. Obtaining an understanding of the entity and its environment, including the entity's internal control, is a continuous, dynamic process of gathering, updating, and analyzing information throughout the audit. The understanding obtained 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. The volume and variety of the financial instrument transactions of an entity typically determine the nature and extent of controls that may exist at an entity. An understanding of how financial instruments are monitored and controlled assists the auditor in determining the nature, timing, and extent of audit procedures.
3.01 AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards), establishes requirements for the auditor to understand the entity and its environment, including its internal control. Obtaining an understanding of the entity and its environment, including the entity's internal control, is a continuous, dynamic process of gathering, updating, and analyzing information throughout the audit. The understanding obtained 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. The volume and variety of the financial instrument transactions of an entity typically determine the nature and extent of controls that may exist at an entity. An understanding of how financial instruments are monitored and controlled assists the auditor in determining the nature, timing, and extent of audit procedures.
3.02 AU-C section 315 requires the auditor to obtain a sufficient understanding of internal control by performing risk assessment procedures to:
- Evaluate the design of controls relevant to an audit of financial statements.
- Determine whether they have been implemented.
The auditor is required to use this knowledge to:
- Identify types of potential misstatements.
- Consider factors that affect the risks of material misstatement.
- Design tests of controls, when applicable, and substantive procedures.
3.03 AU-C section 315 explains that the division of internal control into the following five components, for purposes of GAAS, provides a useful framework for auditors when considering how different aspects of an entity's internal control may affect the audit:
a. The control environment
b. The entity's risk assessment process
c. The information system
d. Control activities
e. Monitoring of controls
3.04 The division does not necessarily reflect how an entity designs, implements, and maintains internal control or how it may classify any particular component. Auditors may use different terminology or frameworks to describe the various aspects of internal control and their effect on the audit other than those used in this section, provided that all the components described in this section are addressed.
3.05 This chapter provides background information and examples of controls that may exist in an entity that deals in a high volume of financial instrument transactions, whether for trading or investing purposes. The examples are not meant to be exhaustive, and entities may establish different control environments and processes depending on their size, the industry in which they operate, and the extent of their financial instrument transactions.
3.06 As in ny control system, it is sometimes necessary to duplicate controls at different control levels (for example, preventative, detective, and monitoring) to avoid the risk of material misstatement.
Developing an Audit Approach
5.09 In testing how management values the financial instrument and in responding to the assessed risks of material misstatement in accordance with paragraphs .12 - .14 of AU-C section 540, the auditor undertakes one or more of the following procedures, taking account of the nature of the accounting estimates:
5.09 In testing how management values the financial instrument and in responding to the assessed risks of material misstatement in accordance with paragraphs .12 - .14 of AU-C section 540, the auditor undertakes one or more of the following procedures, taking account of the nature of the accounting estimates:
- Test how management made the accounting estimate and the data on which it is based (including valuation techniques used by the entity in its valuations).
- Test the operating effectiveness of the controls over how management made the accounting estimate, together with appropriate substantive procedures.
- Develop a point estimate or range to evaluate management's point estimate.
- Determine whether events occurring up to the date of the auditor's report provide audit evidence regarding the accounting estimate
Many auditors find that a combination of testing how management valued the financial instrument and the data on which it is based and testing the operating effectiveness of controls will be an effective and efficient audit approach. Although subsequent events may provide some evidence about the valuation of financial instruments, other factors may need to be taken into account to address any changes in market conditions subsequent to the balance sheet date.3 If the auditor is unable to test how management made the estimate, the auditor may choose to develop a point estimate or range.
5.10 As described in chapter 1, "Gaining an Understanding About Financial Instruments," of this guide, to estimate the fair value of financial instruments, management may:
- Utilize information from third-party pricing sources.
- Gather data to develop its own estimate using various techniques, including models.
- Engage a specialist to develop an estimate.
Management often may use a combination of these approaches. For example, management may have its own pricing process but use third-party pricing sources to corroborate its own values.
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