Audit Procedures for Financial Instruments: Risks, Assertion, Procedures

Financial instruments, such as loans, bonds, and derivatives, play a crucial role in many organizations’ financial statements. The audit of financial instruments is an essential part of a financial statement audit that helps to ensure that these transactions are accurately recorded and reported in accordance with applicable accounting standards.

The purpose of this article is to provide a comprehensive technical overview of audit procedures for financial instruments.

Accounting Treatment:

Accounting for financial instruments under International Financial Reporting Standards (IFRS) involves the recognition, measurement, and disclosure of financial instruments in financial statements.

IFRS 9 Financial Instruments, which is the primary accounting standard for financial instruments, establishes the recognition, measurement, and derecognition criteria for financial assets and liabilities. The standard also provides guidance on the classification and measurement of financial assets and liabilities, as well as impairment and hedge accounting.

The recognition of financial instruments under IFRS 9 is based on the principle that an entity should only recognize a financial asset or liability in its financial statements if it has a contractual obligation to deliver or receive a financial asset or liability.

The measurement of financial instruments is based on their fair value or the amount at which they can be settled. IFRS 9 provides three categories of classification for financial assets: amortized cost, fair value through other comprehensive income (FVOCI), and fair value through profit or loss (FVTPL). The classification depends on the entity’s business model and the nature of the financial asset.

The disclosure requirements under IFRS 9 include information on the entity’s risk management policies, the fair value hierarchy of financial instruments, and significant transfers of financial instruments between categories.

Audit Risks:

The following are ten common audit risks when auditing financial instruments:

1. Misclassification: Financial instruments may be misclassified as other assets or liabilities, leading to incorrect accounting treatments.
2. Fair value measurement: The accuracy of fair value measurements is critical to the accuracy of financial statements.
3. Valuation models: Complex financial instruments may require complex valuation models that are difficult to audit.
4. Impairment: The assessment of impairment of financial assets requires a detailed understanding of the underlying assets and the methodology used to determine impairment.
5. Interest rate risk: The audit of interest rate risk involves understanding the methods used to measure and manage interest rate risk.
6. Counterparty credit risk: The audit of counterparty credit risk involves understanding the methods used to measure and manage counterparty credit risk.
7. Concentration risk: The audit of concentration risk involves understanding the methods used to measure and manage concentration risk.
8. Operational risk: The audit of operational risk involves understanding the methods used to measure and manage operational risk.
9. Compliance with regulations: Financial instruments may be subject to various regulatory requirements, and the audit of compliance with these regulations is an important part of the audit.
10. Data quality: The quality of data used to record and measure financial instruments is critical to the accuracy of financial statements.

Audit Assertions:

The following are six common audit assertions for auditing financial instruments:

1. Existence: The audit assertion of existence confirms that the financial instruments recorded in the financial statements exist.
2. Rights and obligations: The audit assertion of rights and obligations confirms that the organization has the rights and obligations associated with the financial instruments recorded in the financial statements.
3. Valuation: The audit assertion of valuation confirms that the financial instruments are recorded at fair value, amortized cost, or at cost, as appropriate.
4. Completeness: The audit assertion of completeness confirms that all transactions and events related to financial instruments are recorded in the financial statements.
5. Presentation and disclosure: The audit assertion of presentation and disclosure confirms that financial instruments are presented and disclosed in accordance with applicable accounting standards.
6. Accuracy and reliability of data: The audit assertion of accuracy and reliability of data confirms that the data used to record and measure financial instruments is accurate and reliable.

Walkthrough Testing:

Walkthrough testing is an important part of the audit process for financial instruments, as it allows the auditor to understand the entity’s systems and processes for accounting for financial instruments.

The purpose of walkthrough testing is to obtain evidence that supports the auditor’s understanding of the entity’s systems and processes, and to identify areas that may require further testing.

The walkthrough testing process typically involves the auditor observing the entity’s personnel performing the relevant tasks, asking questions about the process, and examining relevant documentation.

The auditor should also assess the entity’s control environment and its internal control over financial reporting. The auditor should also consider the results of any previous walkthrough testing performed, as well as any relevant changes in the entity’s systems and processes since the last walkthrough.

Test of Control:

Test of control is a substantive audit procedure that is performed to evaluate the effectiveness of the entity’s internal controls over financial reporting. The purpose of test of control is to provide evidence to support the auditor’s assessment of the risk of material misstatement and to design further substantive audit procedures that are appropriate for the specific circumstances of the audit.

Test of control procedures typically involve testing the entity’s controls to determine whether they are operating effectively. This may include tests of control over the entity’s systems and processes for financial reporting, as well as tests of the entity’s policies and procedures.

The auditor should also consider the results of any previous test of control procedures performed, as well as any relevant changes in the entity’s systems and processes since the last test of control.

The test of control procedures may include, but are not limited to:

• Observing control activities, such as approvals and reconciliations.
• Performing substantive audit procedures on control-related transactions, such as testing the accuracy and completeness of account balances.
• Testing the entity’s IT general controls, such as security and access controls, to determine if they are functioning as intended.

The results of the test of control procedures should be used to assess the risk of material misstatement, and to design further substantive audit procedures that are appropriate for the specific circumstances of the audit.

Substantive Audit Procedures

Substantive audit procedures for auditing financial instruments can be divided into the following categories:

1. Existence and Valuation: This involves confirming the existence of the financial instrument, its fair value and the accuracy of the underlying data used to determine the fair value. This includes checking documentation such as contracts, trade confirmations and market data to confirm the existence of the financial instrument.
2. Rights and Obligations: This involves verifying that the entity has the right to hold and use the financial instrument, and that it has the obligation to perform any contractual terms. This includes checking the terms and conditions of the contract and understanding the entity’s rights and obligations under the contract.
3. Impairment Testing: This involves assessing whether there is objective evidence of impairment and determining the amount of any impairment loss that should be recognized. This includes reviewing the entity’s impairment testing methodology, documentation and results.
4. Classification: This involves verifying that the financial instrument has been classified correctly in the financial statements. This includes checking the entity’s accounting policies and procedures and confirming that the classification is in accordance with IFRS 9.
5. Transfers and Reclassifications: This involves checking the accuracy of transfers between classes of financial instruments and reclassifications from held-for-trading to held-to-maturity. This includes reviewing the entity’s accounting policies and procedures, and the supporting documentation for transfers and reclassifications.
6. Presentation and Disclosure: This involves verifying that the financial instruments have been correctly presented and disclosed in the financial statements. This includes checking the entity’s accounting policies and procedures and the supporting documentation, as well as the financial statement disclosure.
7. Complex Financial Instruments: This involves assessing the risks associated with complex financial instruments, such as derivatives, and the appropriateness of the entity’s accounting treatment. This includes checking the entity’s accounting policies and procedures, and the underlying data used to determine the fair value of the financial instrument.
8. Significant Accounting Judgments: This involves reviewing the entity’s significant accounting judgments, such as the fair value measurement of financial instruments, to determine whether they are reasonable and in accordance with IFRS 9.
9. Subsequent Events: This involves assessing the impact of subsequent events on the financial statements and the accounting treatment of financial instruments. This includes checking the entity’s accounting policies and procedures, and the underlying data used to determine the fair value of the financial instrument.
10. Validation of Model-Based Approaches: This involves validating the entity’s model-based approaches, such as Monte Carlo simulations, to determine the fair value of financial instruments. This includes reviewing the entity’s modeling methodology, data inputs and outputs, and the results of the model-based approach.