You are the manager in Dee Kay Company, a firm of Chartered Accountants. You have just attended a monthly meeting of audit partners and managers at which client-related matters were discussed. Information relating to one client which were discussed at the meeting is given below.
Tap Co
Tap Co is a clothing manufacturer, which has recently expanded its operations overseas. To manage exposure to cash flows denominated in foreign currencies, the company has set up a treasury management function, which is responsible for entering into hedge transactions such as forward exchange contracts. These transaction are likely to be material to the financial statements. The audit partner is about to commence planning the audit for the year ending 31 July 2014.
Required:
Discuss why the audit of financial instruments is particularly challenging, and explain the matters to be considered in planning the audit of Tap Co’s forward exchange contracts. (10 marks)
View Solution
Financial instrument themselves may be difficult to understand. Management themselves may fail to understand the risks involved with them, which may expose the entity to substantial risks.
Financial reporting requirements in this area can be complex, which increases the risk of misstatement. It is possible that neither management nor the auditor will properly understand how the instruments should be accounted for.
Accounting for financial instrument may also involve an element of subjectivity, eg in determining fair values. Fair values may be estimated with the use of models which will involve making assumptions. Is therefore a risk that the assumptions made by management are not reasonable.
Given the presence of subjectivity, it is all the more important that the auditor is professionally skeptical in this area, although this is likely to be difficult.
Alternatively, some financial instruments may be fairly simple to audit, eg where there is an active market, it may be possible to agree fair values to a broker’s report. This would of course be subject to the requirements of ISA 500 Audit Evidence in relation to the use of a management’s expert.
It may be necessary to make use of an auditor’s expert, in which case the auditor must ensure that the expert is independent and competent, and must evaluate the suitability of the expert’s work as audit evidence. This may not be straightforward to do, given the complexity of the subject matter.
Using an auditor’s expert may also have the effect of increasing the audit fee, which should be explained to and discussed with the client.
Matters to consider
The company’s treasury management function has only been set up recently, so it is possible that there will be problems in an area such as this. Internal controls may not be well established, so the auditor will need to spend time obtaining an understanding of them. This increases audit risk in this area.
Consideration should be given to the level of competence of staff in the new department. If they are skilled in this area then they may be new to the company, in which case there may be difficulties integrating the department with the rest of Tap Co’s finance function.
Alternatively, there is a risk that staff do not have adequate knowledge or experience in this area.
It will be necessary to obtain an understanding of the kinds of financial instruments Tap Co uses to hedge transactions, including Tap Co.’s reasons for entering into them and the kinds of risks it may be exposed to thereby.
The materiality of the instrument should be considered, bearing in mind especially the possibility that transactions with either no, or very little, initial value may turn out to have effect on the financial statements that are material. Some types of derivative financial instruments may fall into this category.
Management’s method for valuing financial instruments should be considered, and the auditor must choose whether to audit management’s valuation model, or whether to construct a model of its own. This would depend on the assessed reliability of internal controls in this area.