The CPA Journal

Auditing Derivatives and Securities

By Paul Munter and Thomas A. Ratcliffe

In Brief

New Guidance for a Complex Arena

Auditors preparing for the implementation of SFAS No. 133 will find special challenges in obtaining sufficient evidence to support management’s assertions about the existence or occurrence, completeness, and valuation of the company’s derivative instruments. To that end, SAS No. 92 was issued to provide guidance in the assessment of inherent and control risk of derivatives and securities and in the design of substantive audit tests to gather sufficient evidential material on which to base audit conclusions. The authors review the principal provisions of SFAS No. 133 and provide detailed suggestions, based on SAS No. 92 and its accompanying audit guide, for the planning and implementation of audits of derivative instruments.

After more than a decade of consideration, evaluation, protest, and consternation on the part of the Financial Accounting Standards Board (FASB) and corporate management, many companies are now in the process of implementing the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. To date, the professional literature has focused on the significant accounting issues raised by SFAS No. 133. In light of the accounting difficulties, FASB has found it necessary to—

defer the implementation of SFAS No. 133 for one year (SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities: Deferral of the Effective Date of FASB Statement No. 133);

modify and clarify certain provisions of SFAS No. 133 (SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities: An amendment of FASB Statement No. 133); and

monitor implementation issues and provide guidance on an ongoing basis through the Derivatives Implementation Group (DIG).

Accounting issues notwithstanding, auditors will face difficult challenges as they audit financial statements that actually include derivatives in the financial statements rather than just disclosures about certain derivatives in the notes. Recognizing these challenges, the Auditing Standards Board (ASB) has provided additional guidance to auditors in SAS No. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities. Issued in September 2000, SAS No. 92 supersedes the previous audit guidance on investment instruments found in SAS No. 81, Auditing Investments. Furthermore, the ASB issued an audit guide, also entitled Auditing Derivative Instruments, Hedging Activities, and Investments in Securities, to accompany SAS No. 92.

SFAS No. 133 Overview

SFAS No. 133 extended the definition of a derivative beyond that used in the finance industry (for a more complete discussion, see “New Accounting for Derivatives and Hedging Activities,” CPA Journal, October 1998 and “New Accounting for Derivatives Illustrated,” CPA Journal, November 1998). According to paragraph 6 of SFAS No. 133, a derivative instrument contains the following characteristics:

It has one or more underlyings (e.g., interest rates, foreign exchange rates, commodity prices) and one or more notional amounts or payment provisions (or both).

It requires no initial net investment or an initial net investment that is smaller than would be required for other contracts that would have a similar response to changes in market factors.

Its terms require or permit net settlement.

Many different types of instruments meet these criteria, including options, swaps, futures and forward contracts, and others.

An objective of SFAS No. 133 was to increase the transparency of information about derivatives. Stated differently, before the adoption of SFAS No. 133, most derivative instruments were not reflected in financial statements because they were accounted for at historical cost, typically zero or a very small, immaterial amount. To address this problem, SFAS No. 133 requires that all derivatives with limited exceptions noted in paragraph 10 be marked to market at each financial statement date. At each balance sheet date, an entity determines the fair value of each derivative instrument and adjusts its value on the balance sheet. The resulting gain or loss from marking the derivative to market would be recognized immediately in income or deferred to equity as an element of other comprehensive income.

The treatment of the gain or loss depends upon whether the derivative qualifies for hedge accounting and, if so, which type of hedge. If a derivative does not qualify as a hedge, then the fair value adjustment to the derivative is recognized immediately in earnings. SFAS No. 133 identifies three types of hedge accounting for derivative instruments:

Fair value hedges are derivatives that hedge a recorded asset, recorded liability, or unrecorded firm commitment. For a fair value hedge, the mark-to-market adjustment on the derivative is included in earnings and the hedged item is marked to market through earnings. If the hedge is effective, the two amounts should offset and have an immaterial effect on earnings.

Cash flow hedges are derivatives that hedge against the variability of anticipated future cash flows. Their gain or loss is deferred—as an element of other comprehensive income—and recognized in earnings in the period when the related cash flow is included in earnings.

Net investment hedges are derivatives or nonderivatives that hedge the foreign exchange rate effect on the net investment of a foreign investee. The gain or loss on these hedges is included as an offset to the cumulative translation adjustment in other comprehensive income.

An important consideration for an auditor is the SFAS No. 133 requirement that the entity designate each derivative individually as a fair value hedge or cash flow hedge in order for hedge accounting treatment to apply. Additionally, the documentation should include—

an identification of the item and risk being hedged,

a description of how the derivative instrument is expected to help the entity manage the economic exposure, and

management’s expectation that the derivative will be highly effective in managing the risk (including an explanation of how effectiveness will be measured).

Finally, the company must monitor the effectiveness of the derivative instrument during the hedging period.

SAS No. 92 Scope and Applicability

According to SAS No. 31, Evidential Matter, auditors must have evidence to support the five different assertions embodied in financial statement elements: existence or occurrence, completeness, rights and obligations, valuation or allocation, and presentation and disclosure. SAS No. 92 applies to assertions about derivative instruments, including both freestanding and embedded derivative instruments of all entities as described in SFAS No. 133.

In addition to derivatives, SAS No. 92 applies to all securities—both debt and equity—using the definitions found in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. However, the provisions of SAS No. 92 apply to debt and equity securities without regard to whether they are subject to the accounting requirements of SFAS No. 115. For example, SAS No. 92 applies to assertions about securities accounted for under the equity method as prescribed by Accounting Principles Board (APB) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock.

Specialized Knowledge for Audit Planning

Because of the difficulties in identifying and valuing derivative instruments, the audit team will need special skills in order to properly plan and perform the auditing procedures needed to obtain sufficient evidence for certain assertions about derivatives and securities. SAS No. 92 provides examples of the auditing procedures and special skills or knowledge needed to satisfy the auditor’s responsibilities applicable to derivatives and investments, including the following:

Obtaining an understanding of an entity’s information system for derivatives and securities, including services provided by a service organization (see SAS No. 88, Service Organizations and Reporting on Consistency) may require special skills or knowledge about computer applications if significant information is transmitted, processed, maintained, or accessed electronically.

Identifying controls at a service organization that operates part of the entity’s information system for derivatives and securities may require that the auditor understand the operating characteristics of both the entity and the service organization.

Understanding the application of GAAP for assertions about derivatives will require special knowledge because of its complexity. In addition, a derivative may have complex features, requiring special knowledge to evaluate its measurement and disclosure. In particular, many derivatives are not freestanding, but are embedded in other contracts or agreements. Nonetheless, according to SFAS No. 133, many of these embedded derivatives will require separate accounting.

Understanding the determination of the fair values of derivatives and securities—including the appropriateness of various types of valuation models and the reasonableness of key factors and assumptions—may require knowledge of valuation concepts.

Assessing inherent risk and control risk for assertions about derivatives used in hedging activities may require an understanding of general risk management concepts and typical asset and liability management strategies.

SAS No. 22, Planning and Supervision, will guide the individuals with such expertise that serve as members of the audit team in planning and performing auditing procedures. If the auditor uses an appropriate external specialist, the provisions of SAS No. 73, Using the Work of a Specialist, will apply in obtaining and evaluating appropriate audit evidence.

Audit Risk and Materiality

SAS No. 47, Audit Risk and Materiality in Conducting an Audit, requires the assessment of audit risk and materiality when planning and performing an audit of financial statements in accordance with GAAS. The design of audit procedures should reasonably assure the detection of misstatements of assertions about derivatives and securities that, when aggregated with misstatements of other assertions, could cause the financial statements taken as a whole to be materially misstated. If the reporting entity is a public company, the guidance found in SEC Staff Accounting Bulletin No. 99, Materiality, also applies.

When designing such procedures, auditors should consider both inherent and control risk for assertions about derivatives. In assessing inherent and control risk applicable to derivatives and securities, auditors should also consider the work performed by the entity’s internal auditors (see SAS No. 65, The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements).

The inherent risk for an assertion about a derivative or security is its susceptibility to material misstatement in the absence of related controls.

SAS No. 55, Consideration of Internal Control in a Financial Statement Audit, as amended by SAS No. 78, Consideration of Internal Control in a Financial Statement Audit: An Amendment to SAS No. 55, requires an understanding of internal control that reasonably assures—

the identification of types of potential misstatements related to assertions

the consideration of factors that affect the risk that misstatements could be material to the financial statements

the design of appropriate substantive tests.

(Exhibit 1) provides an overview of the issues to consider in making an assessment of inherent risk and control risk applicable to derivatives and securities.

Consideration of Service Organization Controls

Based on the provisions of SAS No. 70, Service Organizations, a service organization’s services are part of an entity’s information system for derivatives and securities if they affect any of the following:

The initiation of the entity’s derivatives and securities transactions;

The accounting records, supporting information, and specific accounts in the financial statements involved in the processing and reporting of the entity’s derivatives and securities transactions;

The accounting processing involved, from the initiation of those transactions to their inclusion in the financial statements, including any electronic means (e.g., computers and electronic data interchange) used to transmit, process, maintain, and access information; or

The process used to report information about derivatives and securities transactions in the financial statements, including significant accounting estimates and disclosures.

Examples of a service organization’s services that would be part of an entity’s information system include:

The initiation of the purchase or sale of equity securities by a service organization acting as investment advisor or manager.

Services that are ancillary to holding an entity’s securities, such as—

collecting dividend and interest income and distributing that income to the entity

receiving notification of corporate actions

receiving notification of security purchase and sale transactions

receiving payments from purchasers and disbursing proceeds to sellers for security purchase and sale transactions

Maintaining records of securities transactions for the entity.

A pricing service providing fair values of derivatives and securities through paper documents or electronic downloads that value derivatives and securities for financial statement reporting.

Examples of a service organization’s services that would not be part of an entity’s information system include the execution by a securities broker of trades initiated by either the entity or its investment advisor and the holding of an entity’s securities.

Control Risk Assessment

After obtaining the understanding of inherent risk factors and internal control over derivatives and securities transactions, the auditor will need to make an assessment of control risk for the related assertions in accordance with SAS No. 55 (as amended). If the auditor plans to assess control risk below the maximum level for one or more assertions about derivatives and securities, the identification of specific controls that could prevent or detect material misstatements in operation by either the entity or the service organization is required. Subsequently, the auditor will need to obtain evidence of the operating effectiveness of these control procedures; confirmations of balances or transactions from a service organization do not provide evidential matter (SAS No. 92).

In designing auditing procedures for assertions about derivatives and securities the auditor should consider—

the size of the entity,

its organizational structure,

the nature of its operations,

the types, frequency, and complexity of its derivatives and securities transactions, and

its controls over those transactions.

For example, if the entity has a variety of derivatives and securities for which fair value is determined by valuation models (because observable market value information is not available), the auditor may be able to reduce the substantive procedures for valuation assertions by gathering evidential matter about the models (including the significant assumptions) and evaluating their operating effectiveness.

In many cases, however, the auditor will be unable to reduce the assessment of control risk below the maximum level. In these situations, the auditor would design the substantive tests based upon an assessment of control risk at the maximum level. Since the inherent risk is also high for these instruments, auditors would need to rely on highly effective substantive tests.

Financial Statement Assertions: Existence or Occurrence

Three of the five financial statement assertions require special audit diligence: existence or occurrence, completeness, and valuation. Assertions about rights and obligations and presentation and disclosure are not as problematic in auditing derivatives and securities.

Existence assertions address whether the derivatives and securities reported in the financial statements through recognition or disclosure exist at the financial statement date. Occurrence assertions address whether derivatives and securities transactions reported in the financial statements, whether as a component of earnings, other comprehensive income, or cash flows (and the related disclosure), occurred during the reporting period. (Exhibit 2) provides an overview of the substantive procedures that may be needed to obtain evidence about existence or occurrence assertions applicable to derivatives and securities.

Financial Statement Assertions: Completeness

Before a derivative or investment can be valued, it must first be identified (completeness). Although SAS No. 92 devotes a significant amount of attention to the valuation assertion, the completeness assertion proves most troublesome. Because many derivatives covered by SFAS No. 133 are embedded in other contracts or instruments, the auditor may find it difficult to determine that all derivatives have been identified.

The completeness assertion is satisfied if all of the entity’s derivatives and securities are properly reported in the financial statements and all related transactions are appropriately reported as a component of earnings, other comprehensive income, or cash flows (and the related disclosure). Although the extent of substantive procedures for completeness will vary according to the assessed level of control risk, it may be difficult to limit audit risk for assertions about completeness to an acceptable level with an assessed level of maximum control risk, because so many derivatives do not involve an exchange transaction. Consequently, the auditor will need to use highly effective substantive tests (see Exhibit 3).

Unlike financial instruments, a derivative may involve only a contractual commitment without an initial exchange of tangible consideration. Therefore, when designing tests related to the completeness assertion, auditors should not focus exclusively on evidence relating to cash receipts and disbursements. When testing for completeness, auditors should make inquiries, inspect agreements, and read other contracts and related information, such as the minutes of board or committee meetings. In addition, inquiries about hedged activities will lead to fuller understandings of both operating and accounting risks. For example, if the entity conducts business with foreign entities, the auditor should inquire about any arrangements for purchasing foreign currency. The auditor should inquire about commodity contracts with fixed prices that run for unusual periods of time or involve unusually large quantities (taking into consideration normal business practices). The auditor should also consider inquiring whether the entity used derivatives to convert interest-bearing debt from fixed to variable rates, or vice versa.

Financial Statement Assertions: Valuation

Once all of the derivative and security instruments have been properly identified (completeness and existence or occurrence assertions), then the valuation assertion becomes paramount. The valuation assertion for derivatives and securities addresses whether the amounts reported in the financial statements conform with GAAP. For the vast majority of these instruments, GAAP applies the fair value model. However, GAAP may specify an alternative to fair value, usually the cost or equity method, in limited situations. Additionally, the accounting may call for recognition of gains and losses prior to realization. Furthermore, the accounting model will differ depending upon the type of security, the nature of the transaction, management’s objectives, and the type of entity. For example, if the security is a derivative, the accounting for the unrealized gain or loss will depend upon whether hedge accounting is appropriate and, if so, the type of hedge. For marketable securities accounted for in accordance with the provisions of SFAS No. 115, the accounting will depend upon management’s investment intention (e.g., trading, available-for-sale, and held-to-maturity). As such, the auditor will need to employ a variety of substantive tests to obtain appropriate assurance regarding the valuation assertion. (Exhibit 4) provides an overview of the possible substantive tests.

Valuation based on cost. Procedures to obtain evidence about the cost of securities include—

inspection of purchase price documentation,

confirmation with the issuer or holder, or

testing discount or premium amortization, either by recomputation or analytical procedures.

The auditor should evaluate management’s decision to recognize an impairment loss for a non-temporary decline in the security’s fair value below its cost.

Valuation based on an investee’s financial results (equity method). For valuations based on an investee’s financial results, the auditor should obtain sufficient evidence in their support by reading the investee’s financial statements and accompanying audit report, if any. If, in the auditor’s judgment, additional evidence is needed, the auditor should perform appropriate additional procedures to gather the needed evidence. Such circumstances may include—

significant differences in fiscal year-ends,

significant differences in accounting principles,

changes in ownership,

changes in conditions affecting the use of the equity method, or

the materiality of the investment to the investor’s financial position or results of operations.

Appropriate audit procedures would include a review of information in the investor’s files (e.g., investee board minutes, budgets, and cash flows) and inquiries of investor management about the investee’s financial results.

Valuation based on fair value. Evidence to support management’s assertions about the fair value of derivatives and securities will depend on the method for determining fair value, which may be specified by GAAP and will differ depending on the entity’s operations and industry. Such differences may arise from price quotations from inactive markets, significant liquidity discounts, control premiums, commissions, and other costs that would be incurred in disposing of the derivative or security. In many cases, the determination of fair value will require the use of estimates and surrogate valuation models and compliance with SAS No. 57, Auditing Accounting Estimates.

Quoted market prices are always stronger audit evidence than valuation models and other surrogates for fair value. According to SAS No. 92, quoted market prices obtained from published sources usually provide sufficient audit evidence of the fair value of the derivatives and securities.

Other methods to estimate fair value (including quotations from private brokers and models such as the Black-Scholes option-pricing model) typically require specialized knowledge to properly evaluate. In these situations, the auditor should understand the estimation method and know whether a pricing model or a cash flow projection was used. Estimates from more than one pricing source may be necessary if—

the pricing source has a relationship with an entity that might impair its objectivity, such as an affiliate or a counterparty involved in selling or structuring the derivative product, or

the valuation is based on assumptions that are highly subjective or particularly sensitive to changes in the underlying circumstances.

The auditor must resist the temptation to become an appraiser. It is management’s responsibility to properly value the derivatives and securities. When observable prices are not readily available, possible valuation models include—

the present value of expected future cash flows

option-pricing models

matrix pricing

option-adjusted spread models

fundamental analysis.

Audit procedures to obtain evidence supporting management’s assertions about fair value include the following:

Determining that the valuation model is appropriate for the derivative or security to which it is applied and that assumptions are reasonable and appropriately supported. The evaluation of the appropriateness of valuation models and each of the assumptions used in the models may require considerable judgment and knowledge of valuation techniques, market factors that affect value, and actual and expected market conditions, particularly in relation to similar traded derivatives and securities. Many assessments will require the aid of a specialist.

Recalculating the value by using a model developed independently by the auditor or by a specialist engaged by the auditor to corroborate the reasonableness of the value calculated by the entity.

Comparing the fair value with subsequent or recent transactions.

If quoted prices are not readily available, a significant amount of judgment will be needed to properly evaluate the sufficiency of the evidential matter for the valuation assertion. Because of this, SAS No. 92 strongly urges auditors to consider the guidance provided in SAS No. 57 (auditing estimates) and SAS No. 73 (use of a specialist).

Impairment losses. For securities not subject to mark-to-market accounting, there is the additional issue of whether a nontemporary impairment loss exists, in which case the outcomes from future events determine the amount that should be recognized. The following factors might indicate that there is an impairment loss to be recognized:

Fair value is significantly below cost and—

the decline is attributable to adverse conditions specifically related to the security, an industry, or a geographic area,

the decline has existed for an extended period, or

management does not possess both the intent and the ability to hold the security long enough for any anticipated recovery in fair value.

The security has been downgraded by a rating agency.

The financial condition of the issuer has deteriorated.

Dividends have been reduced or eliminated or scheduled interest payments have not been made.

The entity recorded losses from the security after the end of the reporting period.

Rights and Obligations, Presentation and Disclosure

The assertions of rights and obligations and presentation and disclosure do not pose as many difficulties; nonetheless, the auditor must obtain appropriate audit evidence. The assertion about rights and obligations addresses whether the entity has the rights and obligations associated with derivatives and securities, including pledging arrangements, reported in the financial statements. The auditor should consider—

confirming significant terms with the counterparty to a derivative or the holder of a security, including side agreements

inspecting underlying agreements and other forms of supporting documentation, in paper or electronic form

considering whether the findings of other auditing procedures, such as reviewing minutes of meetings of the board of directors and reading contracts and other agreements, provide evidence (e.g., pledging securities as collateral or selling securities with a commitment to repurchase them).

The assertion about presentation and disclosure addresses whether the classification, description, and disclosure of derivatives and securities in the entity’s financial statements conform with GAAP. In evaluating the adequacy of presentation and disclosure, the auditor should consider the form, arrangement, and content of the financial statements and the notes, including the terminology used, the amount of detail given, the classification of items in the statements, and the bases of amounts reported. The auditor should compare the presentation and disclosure with the requirements of the authoritative literature.

Other Considerations

The accounting treatment for many derivatives and securities depends on management’s intent and the documentation supporting that intent. For derivatives, the accounting depends on whether hedge accounting is appropriate and, if so, what type of hedge accounting is appropriate. Likewise, for securities, the accounting depends on whether there is significant influence (equity accounting) and, if not, what the entity’s investment intent is.

The auditor will need to consider management’s representations regarding its intent and evaluate the accompanying internal documentation to determine its consistency with management’s representations. Furthermore, the auditor will want to consider whether recent transactions and events confirm or contradict management’s previous representations.

Finally, the auditor will need to comply with SAS No. 85, Management Representations, which requires written representations from management confirming its intent and ability to fulfill its assertions about derivatives and securities, such as its intent and ability to hold a debt security until its maturity or to enter into a forecasted transaction for which hedge accounting is applied.

Paul Munter, PhD, CPA, is the KPMG Professor of Accounting and chair of the department of accounting at the University of Miami, Coral Gables, Fla.
Thomas A. Ratcliffe, PhD, CPA, is the Eminent Scholar in Accounting and Finance and dean of the Sorrell College of Business, Troy State University, Troy, Ala.

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