Auditing Derivative Instruments, Hedging Activities, and ...
08 Auditing Financial Instruments
Transcript of 08 Auditing Financial Instruments
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EurofirmHedge Funds training*Auditing Financial InstrumentsSeptember 2007
*connectedthinking
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Slide 2PricewaterhouseCoopersSeptember 2007
Why are we here?
Investment banks and dealers develop new products egweather derivatives, carbon credits
Hedge Funds looking for new ways to generate returns Recent Market Events
- Release of FAS 157- Valuation of hedge fund assets has become a key business
and regulatory issue in the industry.- Sub prime issues in the US and impact on other markets also
Audit Requirements Quality and Consistency Need to Consult
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Slide 3PricewaterhouseCoopersSeptember 2007
Points of Focus
Understand the business drivers
Develop an inventory of investments
Understand the financial instruments that the fund invests in
Control Environment
- Tone at the top
- Management expertise
- Risk management
- Valuation policies and supporting documentation
Materiality
Understand the relevant assertions where we need comfort
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Slide 4PricewaterhouseCoopersSeptember 2007
PwC Practice Aid - A Framework for Auditing FinancialInstruments
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Slide 5PricewaterhouseCoopersSeptember 2007
PwC Practice Aid - A Framework for Auditing FinancialInstruments
Issued on 8 November 2006 and available on the GlobalKnowledge Curve
Contents
How to use the framework
Limitations
Audit Approach
Risks and Controls
Substantive Tests of Details
Evaluating the clients estimate of fair value
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Slide 6PricewaterhouseCoopersSeptember 2007
PwC Practice Aid - A Framework for Auditing FinancialInstruments
Contents (continued)
Use of Valuation Specialists
Impact of valuation issues on the audit report
Appendix 1 Illustrative Control proceduresfor Auditing the Valuation Assertion
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Slide 7PricewaterhouseCoopersSeptember 2007
Limitations of the Framework
Deals with auditing fair values of financialinstruments
Was developed before FAS 157
Fund of Funds should follow AU 332 guidanceand practice aids
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Slide 8PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsAudit Approach (Section 3.1)
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Slide 9PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsHeat Map (Section 3.2)
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Slide 10PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsHeat Map (Section 3.2)
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Slide 11PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsHeat Map Inputs Methodology
Heat Map breaks valuation down into two key parts1- Availability of Inputs: Four Types (Section 3.3.1)
- Readily Available- Discoverable and Objective- Discoverable and Subjective- Derivable or Unobservable- Note: FAS 157 has less options
2- Pricing Methodology: Three Types (Section 3.3.2)- Standard and Objective- Standard but Subjective- Non-Standard
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Slide 12PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsRisks and Controls
Understanding of the Business, and Nature of FinancialInstruments Used
- Is this a new business or a core / ancillarybusiness?
- Does the client have the necessaryinfrastructure to execute, process and accountfor these transactions?
Expertise of client
- Derivatives (exchange-traded, plain vanilla over-the-counter or highly customized products)?
- Equity products (exchange-traded versusinterests in private vehicles, such as privateequity funds)?
- Debt instruments (plain-vanilla versus structuredproducts with embedded derivatives)?
Complexity of thevaluation of theseinstrumentsUse the Heat Map (see Section 3)to make this assessment
- Completeness?
- Volume of transactions (one-off transactionversus frequent buys and sells)?
Population of financialinstruments
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Slide 13PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsRisks and Controls
Understanding of the Business, and Nature of FinancialInstruments Used (continued)
- What can go wrong? Risks
- Investment purposes- Speculative / trading?
- Risk management / hedging (interest rate risk,credit risk, foreign exchange risk, prices)?
Business reasons forentering into thesetransactions
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Slide 14PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsRisks and Controls
Evaluation of Company Level Controls (CLSs) (Section 4.1.3)
Evaluate the effectiveness of the CLCs, because these controlshave a pervasive impact on controls at the process, transactionor application level (See PwC Audit 4170: Company-LevelControls).
CLCs that we intend to rely on must be validated
Policies & Procedures
New Product / Transaction Approval Process
Risk Oversight & Reporting
Model Governance
ITGCs
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Slide 15PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsValuation Controls
Price validation and verification are key controls due to theilliquidity of instruments and modelling challenges at many funds.
Governance around determination and review of fair valuesis a key aspect of the valuation process.
Other Pricing Considerations
Model Control Change control
An inventory of potential controls that might be applicable forfinancial instruments in each box of the Heat Map may be foundin the Framework section 4.2.3
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Slide 16PricewaterhouseCoopersSeptember 2007
Auditing Financial InstrumentsRisk GovernanceKey Challenge: How to ensure Risk Management has teeth Aspects of risk governance include:
- Segregation of duties and defined roles and responsibilities- Defined processes for determination of risk appetite consistent
with disclosures- Escalation of risk issues and reporting to management- Risk Committee independence
Evidence of risk involvement in decision making including: Establishing risk appetite Strategy / transaction approval Due diligence on external managers Risk Measures
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Slide 17PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsRisks and Controls
After considering these factors, engagement teams should be ina position to identify likely Key Risks.
Key Risks: Those conditions or factors within an audit that, inthe judgement of the auditor, give rise to a greater risk ofmaterial financial misstatement or other matters resulting in theissuance of an inappropriate audit report
We often identify too many risks as Key Risks.
Validation of controls
Consult PwC valuation specialists where appropriate.
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Slide 18PricewaterhouseCoopersSeptember 2007
Auditing Financial InstrumentsSummary
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Slide 19PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsSubstantive Tests of Details (Section 5)
Some examples are: Use of IMSAG and investigation of any differences Use of a PwC valuation specialist Confirmation of investments
- Confirmation of value with a counterparty- Confirmation of broker quotes
Review of contracts (for derivatives)An inventory of potential tests of details that might be applicablefor financial instruments in each box of the Heat Map may befound in the Framework section 5.2.1 / 5.2.2
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Slide 20PricewaterhouseCoopersSeptember 2007
Auditing Financial InstrumentsUse of Broker Quotes
Discuss with client the process by which appropriate sources areidentified. Understand if the client has a process in place tovalidate the appropriateness of sources by reviewing transactionaldata, etc. Consider reviewing transactional data to corroborate theappropriateness of a source, especially for large positions forwhich few quotes may be available.
3. Validate appropriatenessof source
Who is providing the quote? Is the firm a market-maker in thesecurity? Does their business include the type of securities forwhich they are providing a quote? Were they the original counter-party to the transaction? Who within the firm is providing thequote? What department are they in? Is this consistent acrossperiods?
2. Know your source
Consider performing additional procedures to the extent only onequote is obtained. Such procedures can include, but are not limitedto, obtaining a valuation memo from the client explaining theposition, the appropriateness of the single source and the reasonswhy additional sources may not be available or appropriate.
1. More is betterCommentsConsiderations
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Slide 21PricewaterhouseCoopersSeptember 2007
Auditing Financial InstrumentsUse of Broker Quotes
Is the client marking to an outlier? How does the client identify ifthe quote is an outlier in the case of multiple quotes? If the client ismarking to a quote which may appear to be an outlier, we shouldunderstand their rationale and obtain supporting/corroboratingaudit evidence. This may require discussion with valuationspecialists.
5. Review for outliers
Document our consideration of the various disclaimers that mayaccompany the quotes received. Understand why the client iscomfortable using these quotes and document accordingly.
4. Consider disclaimersCommentsConsiderations
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Slide 22PricewaterhouseCoopersSeptember 2007
Auditing Financial InstrumentsUse of Broker Quotes
Does the footnote disclosure adequately reflect the use of brokerquotes as a valuation source? Consider fair value disclosureimplications.
7. Review footnotedisclosure
Compare year-end mark to actual transactions before and afteryear-end to assess reasonableness of quotes. Consider reviewingclient's back testing (to the extent performed) or comparingtransactions during year to closest mark to assess reasonablenessof marks during the year.
6. Review actualtransactions
CommentsConsiderations
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Slide 23PricewaterhouseCoopersSeptember 2007
Assessing Clients Determination of fair value
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Slide 24PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsUse of Valuation Specialists
When & Where to User Specialists (Section 7.3)
The decision to engage specialists or experts in the audit isthe responsibility of the engagement leader. Considerationshould begin early in the engagement cycle, either during theAcceptance & Continuance process or during mobilization,but the need for specialists or experts can arise at any timeduring the audit.
Section 7.4 given examples of areas where engagement teamsmay consider using a specialist
Section 7.6 deals with notes and responsibilities when usingspecialists/experts
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Slide 25PricewaterhouseCoopersSeptember 2007
A Framework for Auditing Financial InstrumentsUse of Valuation Specialists
When & Where to User Specialists (Section 7.3) (continued)
Best Practices (Section 7.7)
Set objectives/goals early in the process
Agree upon an anticipated budget and timing
Set scope / approach
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Slide 26PricewaterhouseCoopersSeptember 2007
Auditing Financial InstrumentsImpact of Valuation issues on Audit Report
More Complex the instrument the greater the inherentuncertainty in managements estimated fair value
Section 8 of the framework gives guidance on emphasis ofmatter paragraphs and fair valuation paragraphs
Current Auditing standards have removed the mandatoryrequirement for explanatory paragraph where materialuncertainties exist SAS 79 US GAAS and ISA 620
If there are significant amounts fair valued by managementengagement teams may consider including a fair valuationparagraph consultation is required with Risk managementpartner.
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Slide 27PricewaterhouseCoopersSeptember 2007
Summary
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Slide 28PricewaterhouseCoopersSeptember 2007
Summary
Consider the Valuation Framework guidance and use it inplanning your audit approach
Pay particular attention to using the heat map (section 2)in theaudit planning process, assessing differences in fair valueestimates (section 6) and the use of specialists, if required.
Re-visit the funds valuation policy disclosures to ensure theyare complete and tailored appropriately ensure they fullycomply with accounting requirements (SOP 94-6 disclosure ofcertain significant risks and uncertainties, IAS 32/39 and IFRS7 on Financial Instruments)
Use of Broker Quotes
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