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Guidance Statements

GS 020

Special Considerations in Auditing Financial Instruments

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Approval Date: 8 March 2012

Operative Date This Guidance Statements is operative for financial reporting periods beginning on or after 1 March 2012

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Approval Date: 8 March 2012

This Guidance Statement has been formulated by the Auditing and Assurance Standards Board (AUASB) to provide background information about financial instruments (Section 1) and guidance to auditors on audit considerations relating to financial instruments (Section II).


Includes: Authority Statement

Authority Statement

The Auditing and Assurance Standards Board (AUASB) formulates Guidance Statement GS 020 Special Considerations in Auditing Financial Instruments pursuant to section 227B of the Australian Securities and Investments Commission Act 2001, for the purposes of providing guidance on auditing and assurance matters.


This Guidance Statement provides guidance to assist the auditor to fulfil the objectives of the audit or assurance engagement.  It includes explanatory material on specific matters for the purposes of understanding and complying with AUASB Standards.  The auditor exercises professional judgement when using this Guidance Statement.


The Guidance Statement does not prescribe or create new requirements.


Aus 0.1

This Guidance Statement has been formulated by the Auditing and Assurance Standards Board (AUASB) to provide background information about financial instruments (Section 1) and guidance to auditors on audit considerations relating to financial instruments (Section II).

Issuance Date

Aus 0.2

This Guidance Statement is issued on 8 March 2012 by the AUASB and replaces AGS 1030 Auditing Derivative Financial Instruments.



Financial instruments may be used by financial and non-financial entities of all sizes for a variety of purposes. Some entities have large holdings and transaction volumes while other entities may only engage in a few financial instrument transactions. Some entities may take positions in financial instruments to assume and benefit from risk while other entities may use financial instruments to reduce certain risks by hedging or managing exposures. This Guidance Statement is relevant to all of these situations.


The following Australian Auditing Standards are particularly relevant to audits of financial instruments:

  1. ASA 540[1] deals with the auditor’s responsibilities relating to auditing accounting estimates, including accounting estimates related to financial instruments measured at fair value;
  2. ASA 315[2] and ASA 330[3] deal with identifying and assessing risks of material misstatement and responding to those risks; and
  3. ASA 500[4] explains what constitutes audit evidence and deals with the auditor’s responsibility to design and perform audit procedures to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the auditor’s opinion.


[Deleted by the AUASB. Refer Aus 0.1].


This Guidance Statement is relevant to entities of all sizes, as all entities may be subject to risks of material misstatement when using financial instruments.


The guidance on valuation[5] in this Guidance Statement is likely to be more relevant for financial instruments measured or disclosed at fair value, while the guidance on areas other than valuation applies equally to financial instruments either measured at fair value or amortised cost. This Guidance Statement is also applicable to both financial assets and financial liabilities. This Guidance Statement does not deal with instruments such as:

  1. The simplest financial instruments such as cash, simple loans, trade accounts receivable and trade accounts payable;
  2. Investments in unlisted equity instruments; or
  3. Insurance contracts.


Also, this Guidance Statement does not deal with specific accounting issues relevant to financial instruments, such as hedge accounting, profit or loss on inception (often known as “Day 1” profit or loss), offsetting, risk transfers or impairment, including loan loss provisioning. Although these subject matters can relate to an entity’s accounting for financial instruments, a discussion of the auditor’s consideration regarding how to address specific accounting requirements is beyond the scope of this Guidance Statement.


An audit in accordance with Australian Auditing Standards is conducted on the premise that management and, where appropriate, those charged with governance have acknowledged certain responsibilities. Such responsibilities subsume making fair value measurements. This Guidance Statement does not impose responsibilities on management or those charged with governance nor override laws and regulation that govern their responsibilities.


This Guidance Statement has been written in the context of general purpose fair presentation financial reporting frameworks, but may also be useful, as appropriate in the circumstance, in other financial reporting frameworks such as special purpose financial reporting frameworks.

Aus 8.1

Australian Accounting Standards on financial instruments include AASB 7 Financial Instruments: Disclosures, AASB 132 Financial Instruments: Presentation, AASB 139 Financial Instruments: Recognition and Measurement, AASB 9 Financial Instruments and AASB 13 Fair Value Measurement.


This Guidance Statement focuses on the assertions of valuation, and presentation and disclosure, but also covers, in less detail, completeness, accuracy, existence, and rights and obligations.


Financial instruments are susceptible to estimation uncertainty, which is defined in ASA 540 as “the susceptibility of an accounting estimate and related disclosures to an inherent lack of precision in its measurement.”[6] Estimation uncertainty is affected by the complexity of financial instruments, among other factors. The nature and reliability of information available to support the measurement of financial instruments varies widely, which affects the estimation uncertainty associated with their measurement. This Guidance Statement uses the term “measurement uncertainty” to refer to the estimation uncertainty associated with fair value measurements.


See ASA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.


See ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment.


See ASA 330 The Auditor’s Responses to Assessed Risks.


See ASA 500 Audit Evidence.


In this Guidance Statement, the terms “valuation” and “measurement” are used interchangeably.


See ASA 540, paragraph 7(c).

Section I—Background Information about Financial Instruments

Includes: Purpose and Risks of Using Financial Instruments, Controls Relating to Financial Instruments, Completeness, Accuracy, and Existence , Valuation of Financial Instruments, Presentation and Disclosure about Financial Instruments


Different definitions of financial instruments may exist among financial reporting frameworks. For example, Australian Accounting Standards define a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.[7] Financial instruments may be cash, the equity of another entity, the contractual right or obligation to receive or deliver cash or exchange financial assets or liabilities, certain contracts settled in an entity’s own equity instruments, certain contracts on non-financial items, or certain contracts issued by insurers that do not meet the definition of an insurance contract. This definition encompasses a wide range of financial instruments from simple loans and deposits to complex derivatives, structured products, and some commodity contracts.


Financial instruments vary in complexity, though the complexity of the financial instrument can come from difference sources, such as:

  • A very high volume of individual cash flows, where a lack of homogeneity requires analysis of each one or a large number of grouped cash flows to evaluate, for example, credit risk (for example, collateralised debt obligations (CDOs)).
  • Complex formulae for determining the cash flows.
  • Uncertainty or variability of future cash flows, such as that arising from credit risk, option contracts or financial instruments with lengthy contractual terms.


The higher the variability of cash flows to changes in market conditions, the more complex and uncertain the fair value measurement of the financial instrument is likely to be. In addition, sometimes financial instruments that, ordinarily, are relatively easy to value become complex to value because of particular circumstances, for example, instruments for which the market has become inactive or which have lengthy contractual terms. Derivatives and structured products become more complex when they are a combination of individual financial instruments. In addition, the accounting for financial instruments under certain financial reporting frameworks or certain market conditions may be complex.


Another source of complexity is the volume of financial instruments held or traded. While a “plain vanilla” interest rate swap may not be complex, an entity holding a large number of them may use a sophisticated information system to identify, value and transact these instruments.

Purpose and Risks of Using Financial Instruments


Financial instruments are used for:

  • Hedging purposes (that is, to change an existing risk profile to which an entity is exposed). This includes:
    • The forward purchase or sale of currency to fix a future exchange rate;
    • Converting future interest rates to fixed rates or floating rates through the use of swaps; and
    • The purchase of option contracts to provide an entity with protection against a particular price movement, including contracts which may contain embedded derivatives;
  • Trading purposes (for example, to enable an entity to take a risk position to benefit from short term market movements); and
  • Investment purposes (for example, to enable an entity to benefit from long term investment returns).


The use of financial instruments can reduce exposures to certain business risks, for example changes in exchange rates, interest rates and commodity prices, or a combination of those risks. On the other hand, the inherent complexities of some financial instruments also may result in increased risk.


Business risk and the risk of material misstatement increase when management and those charged with governance:

  • Do not fully understand the risks of using financial instruments and have insufficient skills and experience to manage those risks;
  • Do not have the expertise to value them appropriately in accordance with the applicable financial reporting framework;
  • Do not have sufficient controls in place over financial instrument activities; or
  • Inappropriately hedge risks or speculate.


Management’s failure to fully understand the risks inherent in a financial instrument can have a direct effect on management’s ability to manage these risks appropriately, and may ultimately threaten the viability of the entity.


The principal types of risk applicable to financial instruments are listed below. This list is not meant to be exhaustive and different terminology may be used to describe these risks or classify the components of individual risks.

  1. Credit (or counterparty) risk is the risk that one party to a financial instrument will cause a financial loss to another party by failing to discharge an obligation and is often associated with default. Credit risk includes settlement risk, which is the risk that one side of a transaction will be settled without consideration being received from the customer or counterparty.
  2. Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Examples of market risk include currency risk, interest rate risk, and commodity and equity price risk.
  3. Liquidity risk includes the risk of not being able to buy or sell a financial instrument at an appropriate price in a timely manner due to a lack of marketability for that financial instrument.
  4. Operational risk relates to the specific processing required for financial instruments. Operational risk may increase as the complexity of a financial instrument increases, and poor management of operational risk may increase other types of risk. Operational risk includes:
    1. The risk that confirmation and reconciliation controls are inadequate resulting in incomplete or inaccurate recording of financial instruments;
    2. The risks that there is inappropriate documentation of transactions and insufficient monitoring of these transactions;
    3. The risk that transactions are incorrectly recorded, processed or risk managed and, therefore, do not reflect the economics of the overall trade;
    4. The risk that undue reliance is placed by staff on the accuracy of valuation techniques, without adequate review, and transactions are therefore incorrectly valued or their risk is improperly measured;
    5. The risk that the use of financial instruments is not adequately incorporated into the entity’s risk management policies and procedures;
    6. The risk of loss resulting from inadequate or failed internal processes and systems, or from external events, including the risk of fraud from both internal and external sources;
    7. The risk that there is inadequate or non-timely maintenance of valuation techniques used to measure financial instruments; and
    8. Legal risk, which is a component of operational risk, and relates to losses resulting from a legal or regulatory action that invalidates or otherwise precludes performance by the end user or its counterparty under the terms of the contract or related netting arrangements. For example, legal risk could arise from insufficient or incorrect documentation for the contract, an inability to enforce a netting arrangement in bankruptcy, adverse changes in tax laws, or statutes that prohibit entities from investing in certain types of financial instruments.


Other considerations relevant to risks of using financial instruments include:

  • The risk of fraud that may be increased if, for example, an employee in a position to perpetrate a financial fraud understands both the financial instruments and the processes for accounting for them, but management and those charged with governance have a lesser degree of understanding.
  • The risk that master netting arrangements[8] may not be properly reflected in the financial report.
  • The risk that some financial instruments may change between being assets or liabilities during their term and that such change may occur rapidly.


See Australian Accounting Standard 132 (AASB 132) Financial Instruments: Presentation, paragraph 11.


An entity that undertakes a number of financial instrument transactions with a single counterparty may enter into a master netting arrangement with that counterparty. Such an agreement provides for a single net settlement of all financial instruments covered by the agreement in the event of default of any one contract.

Controls Relating to Financial Instruments


The extent of an entity’s use of financial instruments and the degree of complexity of the instruments are important determinants of the necessary level of sophistication of the entity’s internal control. For example, smaller entities may use less structured products and simple processes and procedures to achieve their objectives.


Often, it is the role of those charged with governance to set the tone regarding, and approve and oversee the extent of use of, financial instruments while it is management’s role to manage and monitor the entity’s exposures to those risks. Management and, where appropriate, those charged with governance are also responsible for designing and implementing a system of internal control to enable the preparation of financial report in accordance with the applicable financial reporting framework. An entity’s internal control over financial instruments is more likely to be effective when management and those charged with governance have:

  1. Established an appropriate control environment, including active participation by those charged with governance in controlling the use of financial instruments, a logical organisational structure with clear assignment of authority and responsibility, and appropriate human resource policies and procedures. In particular, clear rules are needed on the extent to which those responsible for financial instrument activities are permitted to act. Such rules have regard to any legal or regulatory restrictions on using financial instruments. For example, certain public sector entities may not have the power to conduct business using derivatives;
  2. Established a risk management process relative to the size of the entity and the complexity of its financial instruments (for example, in some entities a formal risk management function may exist);
  3. Established information systems that provide those charged with governance with an understanding of the nature of the financial instrument activities and the associated risks, including adequate documentation of transactions;
  4. Designed, implemented and documented a system of internal control to:
    • Provide reasonable assurance that the entity’s use of financial instruments is within its risk management policies;
    • Properly present financial instruments in the financial report;
    • Ensure that the entity is in compliance with applicable laws and regulations; and
    • Monitor risk. The Appendix provides examples of controls that may exist in an entity that deals in a high volume of financial instrument transactions; and
  5. Established appropriate accounting policies, including valuation policies, in accordance with the applicable financial reporting framework.


Key elements of risk management processes and internal control relating to an entity’s financial instruments include:

  • Setting an approach to define the amount of risk exposure that the entity is willing to accept when engaging in financial instrument transactions (this may be referred to as its “risk appetite”), including policies for investing in financial instruments, and the control framework in which the financial instrument activities are conducted;
  • Establishing processes for the documentation and authorisation of new types of financial instrument transactions which consider the accounting, regulatory, legal, financial and operational risks that are associated with such instruments;
  • Processing financial instrument transactions, including confirmation and reconciliation of cash and asset holdings to external statements, and the payments process;
  • Segregation of duties between those investing or trading in the financial instruments and those responsible for processing, valuing and confirming such instruments. For example, a model development function that is involved in assisting in pricing deals is less objective than one that is functionally and organisationally separate from the front office;
  • Valuation processes and controls, including controls over data obtained from third-party pricing sources; and
  • Monitoring of controls.


The nature of risks often differs between entities with a high volume and variety of financial instruments and those with only a few financial instrument transactions. This results in different approaches to internal control. For example:

  • Typically, an institution with high volumes of financial instruments will have a dealing room type environment in which there are specialist traders and segregation of duties between those traders and the back office (which refers to the operations function that data-checks trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers). In such environments, the traders will typically initiate contracts verbally over the phone or via an electronic trading platform. Capturing relevant transactions and accurately recording financial instruments in such an environment is significantly more challenging than for an entity with only a few financial instruments, whose existence and completeness often can be confirmed with a bank confirmation to a few banks.
  • On the other hand, entities with only a small number of financial instruments often do not have segregation of duties, and access to the market is limited. In such cases, although it may be easier to identify financial instrument transactions, there is a risk that management may rely on a limited number of personnel, which may increase the risk that unauthorised transactions may be initiated or transactions may not be recorded.

Completeness, Accuracy, and Existence


Paragraphs 25–33 of this Guidance Statement describe controls and processes which may be in place in entities with a high volume of financial instrument transactions, including those with trading rooms. By contrast, an entity that does not have a high volume of financial instrument transactions may not have these controls and processes but may instead confirm their transactions with the counterparty or clearing house. Doing so may be relatively straightforward in that the entity may only transact with one or two counterparties.

Trade Confirmations and Clearing Houses


Generally, for transactions undertaken by financial institutions, the terms of financial instruments are documented in confirmations exchanged between counterparties and legal agreements. Clearing houses serve to monitor the exchange of confirmations by matching trades and settling them. A central clearing house is associated with an exchange and entities that clear through clearing houses typically have processes to manage the information delivered to the clearing house.


Not all transactions are settled through such an exchange. In many other markets there is an established practice of agreeing the terms of transactions before settlement begins. To be effective, this process needs to be run separately from those who trade the financial instruments to minimise the risk of fraud. In other markets, transactions are confirmed after settlement has begun and sometimes confirmation backlogs result in settlement beginning before all terms have been fully agreed. This presents additional risk because the transacting entities need to rely on alternative means of agreeing trades. These may include:

  • Enforcing rigorous reconciliations between the records of those trading the financial instruments and those settling them (strong segregation of duties between the two are important), combined with strong supervisory controls over those trading the financial instruments to ensure the integrity of the transactions;
  • Reviewing summary documentation from counterparties that highlights the key terms even if the full terms have not been agreed; and
  • Thorough review of traders’ profits and losses to ensure that they reconcile to what the back office has calculated.

Reconciliations with Banks and Custodians


Some components of financial instruments, such as bonds and shares, may be held in separate depositories. In addition, most financial instruments result in payments of cash at some point and often these cash flows begin early in the contract’s life. These cash payments and receipts will pass through an entity’s bank account. Regular reconciliation of the entity’s records to external banks’ and custodians’ records enables the entity to ensure transactions are properly recorded.


It should be noted that not all financial instruments result in a cash flow in the early stages of the contract’s life or are capable of being recorded with an exchange or custodian. Where this is the case, reconciliation processes will not identify an omitted or inaccurately recorded trade and confirmation controls are more important. Even where such a cash flow is accurately recorded in the early stages of an instrument’s life, this does not ensure that all characteristics or terms of the instrument (for example, the maturity or an early termination option) have been recorded accurately.


In addition, cash movements may be quite small in the context of the overall size of the trade or the entity’s own balance sheet and may therefore be difficult to identify. The value of reconciliations is enhanced when finance, or other back office staff, review entries in all general ledger accounts to ensure that they are valid and supportable. This process will help identify if the other side to cash entries relating to financial instruments has not been properly recorded. Reviewing suspense and clearing accounts is important regardless of the account balance, as there may be offsetting reconciling items in the account.


In entities with a high volume of financial instrument transactions, reconciliation and confirmation controls may be automated and, if so, adequate IT controls need to be in place to support them. In particular, controls are needed to ensure that data is completely and accurately picked up from external sources (such as banks and custodians) and from the entity’s records and is not tampered with before or during reconciliation. Controls are also needed to ensure that the criteria on which entries are matched are sufficiently restrictive to prevent inaccurate clearance of reconciling items.

Other Controls over Completeness, Accuracy, and Existence


The complexity inherent in some financial instruments means that it will not always be obvious how they should be recorded in the entity’s systems. In such cases, management may set up control processes to monitor policies that prescribe how particular types of transactions are measured, recorded and accounted for. These policies are typically established and reviewed in advance by suitably qualified personnel who are capable of understanding the full effects of the financial instruments being booked.


Some transactions may be cancelled or amended after initial execution. Application of appropriate controls relating to cancellation or amendment can mitigate the risks of material misstatement due to fraud or error. In addition, an entity may have a process in place to reconfirm trades that are cancelled or amended.


In financial institutions with a high volume of trading, a senior employee typically reviews daily profits and losses on individual traders’ books to evaluate whether they are reasonable based on the employee’s knowledge of the market. Doing so may enable management to determine that particular trades were not completely or accurately recorded, or may identify fraud by a particular trader. It is important that there are transaction authorisation procedures that support the more senior review.

Valuation of Financial Instruments

Financial Reporting Requirements


In many financial reporting frameworks, including Australian Accounting Standards, financial instruments, including embedded derivatives, are often measured at fair value for the purpose of balance sheet presentation, calculating profit or loss, and/or disclosure. In general, the objective of fair value measurement is to arrive at the price at which an orderly transaction would take place between market participants at the measurement date under current market conditions; that is, it is not the transaction price for a forced liquidation or distressed sale. In meeting this objective, all relevant available market information is taken into account.


Fair value measurements of financial assets and financial liabilities may arise both at the initial recording of transactions and later when there are changes in value. Changes in fair value measurements that occur over time may be treated in different ways under different financial reporting frameworks. For example, such changes may be recorded as profit or loss, or may be recorded in the other comprehensive income. Also, depending on the applicable financial reporting framework, the whole financial instrument or only a component of it (for example, an embedded derivative when it is separately accounted for) may be required to be measured at fair value.


Some financial reporting frameworks, for example, Australian Accounting Standards, establish a fair value hierarchy to develop increased consistency and comparability in fair value measurements and related disclosures. The inputs may be classified into different levels such as:

  • Level 1 inputs―Quoted prices (unadjusted) in active markets for identical financial assets or financial liabilities that the entity can access at the measurement date.
  • Level 2 inputs―Inputs other than quoted prices included within level 1 that are observable for the financial asset or financial liability, either directly or indirectly. If the financial asset or financial liability has a specified (contractual) term, a level 2 input must be observable for substantially the full term of the financial asset or financial liability. Level 2 inputs include the following:
    • Quoted prices for similar financial assets or financial liabilities in active markets.
    • Quoted prices for identical or similar financial assets or financial liabilities in markets that are not active.
    • Inputs other than quoted prices that are observable for the financial asset or financial liability (for example, interest rates and yield curves observable at commonly quoted intervals, implied volatilities and credit spreads).
    • Inputs that are derived principally from, or corroborated by, observable market data by correlation or other means (market-corroborated inputs).
  • Level 3 inputs―Unobservable inputs for the financial asset or financial liability. Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the financial asset or financial liability at the measurement date.


In general, measurement uncertainty increases as a financial instrument moves from level 1 to level 2, or level 2 to level 3. Also, within level 2 there may be a wide range of measurement uncertainty depending on the observability of inputs, the complexity of the financial instrument, its valuation, and other factors.


Australian Accounting Standards may require or permit the entity to adjust for measurement uncertainties, in order to adjust for risks that a market participant would make in the pricing to take account of the uncertainties of the risks associated with the pricing or cash flows of the financial instrument. For example:

  • Model adjustments. Some models may have a known deficiency or the result of calibration may highlight the deficiency for the fair value measurement in accordance with the financial reporting framework.
  • Credit-risk adjustments. Some models do not take into account credit risk, including counterparty risk or own credit risk.
  • Liquidity adjustments. Some models calculate a mid-market price, even though the financial reporting framework may require use of a liquidity adjusted amount such as a bid/offer spread. Another, more judgemental, liquidity adjustment recognises that some financial instruments are illiquid which affects the valuation.
  • Other risk adjustments. A value measured using a model that does not take into account all other factors that market participants would consider in pricing the financial instrument may not represent fair value on the measurement date, and therefore may need to be adjusted separately to comply with the applicable financial reporting framework.


Adjustments are not appropriate if they adjust the measurement and valuation of the financial instrument away from fair value as defined by the applicable financial reporting framework, for example for conservatism.

Observable and Unobservable Inputs


As mentioned above, financial reporting frameworks often categorise inputs according to the degree of observability. As activity in a market for financial instruments declines and the observability of inputs declines, measurement uncertainty increases. The nature and reliability of information available to support valuation of financial instruments varies depending on the observability of inputs to its measurement, which is influenced by the nature of the market (for example, the level of market activity and whether it is through an exchange or over-the-counter (OTC)). Accordingly, there is a continuum of the nature and reliability of evidence used to support valuation, and it becomes more difficult for management to obtain information to support a valuation when markets become inactive and inputs become less observable.


When observable inputs are not available, an entity uses unobservable inputs (level 3 inputs) that reflect the assumption that market participants would use when pricing the financial asset or the financial liability, including assumptions about risk. Unobservable inputs are developed using the best information available in the circumstances. In developing unobservable inputs, an entity may begin with its own data, which is adjusted if reasonably available information indicates that (a) other market participants would use different data or (b) there is something particular to the entity that is not available to other market participants (for example, an entity-specific synergy).

Effects of Inactive Markets


Measurement uncertainty increases and valuation is more complicated when the markets in which financial instruments or their component parts are traded become inactive. There is no clear point at which an active market becomes inactive, though financial reporting frameworks, including Australian Accounting Standards, may provide guidance on this issue. Characteristics of an inactive market include a significant decline in the volume and level of trading activity, available prices vary significantly over time or among market participants or the prices are not current. However, assessing whether a market is inactive requires judgement.


When markets are inactive, prices quoted may be stale (that is, out of date), may not represent prices at which market participants may trade or may represent forced transactions (such as when a seller is required to sell an asset to meet regulatory or legal requirements, needs to dispose of an asset immediately to create liquidity or the existence of a single potential buyer as a result of the legal or time restrictions imposed). Accordingly, valuations are developed based on level 2 and level 3 inputs. Under such circumstances, entities may have:

  • A valuation policy that includes a process for determining whether level 1 inputs are available;
  • An understanding of how particular prices or inputs from external sources used as inputs to valuation techniques were calculated in order to assess their reliability. For example, in an active market, a broker quote on a financial instrument that has not traded is likely to reflect actual transactions on a similar financial instrument, but, as the market becomes less active, the broker quote may rely more on proprietary valuation techniques to determine prices;
  • An understanding of how deteriorating business conditions affect the counterparty, as well as whether deteriorating business conditions in entities similar to the counterparty may indicate that the counterparty may not fulfil its obligations (that is, non-performance risk);
  • Policies for adjusting for measurement uncertainties. Such adjustments can include model adjustments, lack of liquidity adjustments, credit risk adjustments, and other risk adjustments;
  • The capability to calculate the range of realistic outcomes given the uncertainties involved, for example by performing a sensitivity analysis; and
  • Policies for identifying when a fair value measurement input moves to a different level of the fair value hierarchy.


Particular difficulties may develop where there is severe curtailment or even cessation of trading in particular financial instruments. In these circumstances, financial instruments that have previously been valued using market prices may need to be valued using a model.

Management’s Valuation Process


Techniques that management may use to value their financial instruments include observable prices, recent transactions, and models that use observable or unobservable inputs. Management may also make use of:

  1. A third-party pricing source, such as a pricing service or broker quote; or
  2. A valuation expert.


Third-party pricing sources and valuation experts may use one or more of these valuation techniques.


In many financial reporting frameworks, including Australian Accounting Standards, the best evidence of a financial instrument’s fair value is found in contemporaneous transactions in an active market (that is, level 1 inputs). In such cases, the valuation of a financial instrument may be relatively simple. Quoted prices for financial instruments that are listed on exchanges or traded in liquid over-the-counter markets may be available from sources such as financial publications, the exchanges themselves or third-party pricing sources. When using quoted prices, it is important that management understand the basis on which the quote is given to ensure that the price reflects market conditions at the measurement date. Quoted prices obtained from publications or exchanges may provide sufficient evidence of fair value when, for example:

  1. The prices are not out of date or “stale” (for example, if the quote is based on the last traded price and the trade occurred some time ago); and
  2. The quotes are prices at which dealers would actually trade the financial instrument with sufficient frequency and volume.


Where there is no current observable market price for the financial instrument (that is, a level 1 input), it will be necessary for the entity to gather other price indicators to use in a valuation technique to value the financial instrument. Price indicators may include:

  • Recent transactions, including transactions after the date of the financial statements in the same instrument. Consideration is given to whether an adjustment needs to be made for changes in market conditions between the measurement date and the date the transaction was made, as these transactions are not necessarily indicative of the market conditions that existed at the date of the financial statements. In addition it is possible that the transaction represents a forced transaction and is therefore not indicative of a price in an orderly trade.
  • Current or recent transactions in similar instruments, often known as “proxy pricing.” Adjustments will need to be made to the price of the proxy to reflect the differences between them and the instrument being priced, for example, to take account of differences in liquidity or credit risk between the two instruments.
  • Indices for similar instruments. As with transactions in similar instruments, adjustments will need to be made to reflect the difference between the instrument being priced and the instrument(s) from which the index used is derived.


It is expected that management will document its valuation policies and model used to value a particular financial instrument, including the rationale for the model(s) used, the selection of assumptions in the valuation methodology, and the entity’s consideration of whether adjustments for measurement uncertainty are necessary.



Models may be used to value financial instruments when the price cannot be directly observed in the market. Models can be as simple as a commonly used bond pricing formula or involve complex, specifically developed software tools to value financial instruments with level 3 inputs. Many models are based on discounted cash flow calculations.


Models comprise a methodology, assumptions and data. The methodology describes rules or principles governing the relationship between the variables in the valuation. Assumptions include estimates of uncertain variables which are used in the model. Data may comprise actual or hypothetical information about the financial instrument, or other inputs to the financial instrument.


Depending on the circumstances, matters that the entity may address when establishing or validating a model for a financial instrument include whether:

  • The model is validated prior to usage, with periodic reviews to ensure it is still suitable for its intended use. The entity’s validation process may include evaluation of:
    • The methodology’s theoretical soundness and mathematical integrity, including the appropriateness of parameters and sensitivities.
    • The consistency and completeness of the model’s inputs with market practices, and whether the appropriate inputs are available for use in the model.
  • There are appropriate change control policies, procedures and security controls over the model.
  • The model is appropriately changed or adjusted on a timely basis for changes in market conditions.
  • The model is periodically calibrated, reviewed and tested for validity by a separate and objective function. Doing so is a means of ensuring that the model’s output is a fair representation of the value that marketplace participants would ascribe to a financial instrument.
  • The model maximises the use of relevant observable inputs and minimises the use of unobservable inputs.
  • Adjustments are made to the output of the model to reflect the assumptions marketplace participants would use in similar circumstances.
  • The model is adequately documented, including the model’s intended applications and limitations and its key parameters, required data, results of any validation analysis performed and any adjustments made to the output of the model.

An Example of a Common Financial Instrument


The following describes how models may be applied to value a common financial instrument, known as an asset backed security.[9] Because asset backed securities are often valued based on level 2 or 3 inputs, they are frequently valued using models and involve:

  • Understanding the type of security—considering (a) the underlying collateral; and (b) the terms of the security. The underlying collateral is used to estimate the timing and amounts of cash flows such as mortgage or credit card interest and principal payments.
  • Understanding the terms of the security—this includes evaluating contractual cash flow rights, such as the order of repayment, and any default events. The order of repayment, often known as seniority, refers to terms which require that some classes of security holders (senior debt) are repaid before others (subordinated debt). The rights of each class of security holder to the cash flows, frequently referred to as the cash flow “waterfall,” together with assumptions of the timing and amount of cash flows are used to derive a set of estimated cash flows for each class of security holder. The expected cash flows are then discounted to derive an estimated fair value.


The cash flows of an asset backed security may be affected by prepayments of the underlying collateral and by potential default risk and resulting estimated loss severities. Prepayment assumptions, if applicable, are generally based on evaluating market interest rates for similar collateral to the rates on the collateral underlying the security. For example, if market interest rates for mortgages have declined then the underlying mortgages in a security may experience higher prepayment rates than originally expected. Estimating potential default and loss severity involves close evaluation of the underlying collateral and borrowers to estimate default rates. For example, when the underlying collateral comprises residential mortgages, loss severities may be affected by estimates of residential housing prices over the term of the security.

Third-Party Pricing Sources


Entities may use third-party pricing sources in order to obtain fair value information. The preparation of an entity’s financial statements, including the valuation of financial instruments and the preparation of financial statement disclosures relating to these instruments, may require expertise that management does not possess. Entities may not be able to develop appropriate valuation techniques, including models that may be used in a valuation, and may use a third-party pricing source to arrive at a valuation or to provide disclosures for the financial statements. This may particularly be the case in smaller entities or in entities that do not engage in a high volume of financial instruments transactions (for example, non-financial institutions with treasury departments). Even though management has used a third-party pricing source, management is ultimately responsible for the valuation.


Third-party pricing sources may also be used because the volume of securities to price over a short timeframe may not be possible by the entity. This is often the case for traded investment funds that must determine a net asset value each day. In other cases, management may have their own pricing process but use third-party pricing sources to corroborate their own valuations.


For one or more of these reasons most entities use third-party pricing sources when valuing securities either as a primary source or as a source of corroboration for their own valuations. Third-party pricing sources generally fall into the following categories:

  • Pricing services, including consensus pricing services; and
  • Brokers proving broker quotes.

Pricing services


Pricing services provide entities with prices and price-related data for a variety of financial instruments, often performing daily valuations of large numbers of financial instruments. These valuations may be made by collecting market data and prices from a wide variety of sources, including market makers, and, in certain instances, using internal valuations techniques to derive estimated fair values. Pricing services may combine a number of approaches to arrive at a price. Pricing services are often used as a source of prices based on level 2 inputs. Pricing services may have strong controls around how prices are developed and their customers often include a wide variety of parties, including buy and sell side investors, back and middle office functions, auditors and others.


Pricing services often have a formalised process for customers to challenge the prices received from the pricing services. These challenge processes usually require the customer to provide evidence to support an alternative price, with challenges categorised based on the quality of evidence provided. For example, a challenge based on a recent sale of that instrument that the pricing service was not aware of may be upheld, whereas a challenge based on a customer’s own valuation technique may be more heavily scrutinised. In this way, a pricing service with a large number of leading participants, both buy and sell side, may be able to constantly correct prices to more fully reflect the information available to market participants.

Consensus pricing services


Some entities may use pricing data from consensus pricing services which differ from other pricing services. Consensus pricing services obtain pricing information about an instrument from several participating entities (subscribers). Each subscriber submits prices to the pricing service. The pricing service treats this information confidentially and returns to each subscriber the consensus price, which is usually an arithmetical average of the data after a data cleansing routine has been employed to eliminate outliers. For some markets, such as for exotic derivatives, consensus prices might constitute the best available data. However, many factors are considered when assessing the representational faithfulness of the consensus prices including, for example:

  • Whether the prices submitted by the subscribers reflect actual transactions or just indicative prices based on their own valuation techniques.
  • The number of sources from which prices have been obtained.
  • The quality of the sources used by the consensus pricing service.
  • Whether participants include leading market participants.


Typically consensus prices are only available to subscribers who have submitted their own prices to the service. Accordingly not all entities will have direct access to consensus prices. Because a subscriber generally cannot know how the prices submitted were estimated, other sources of evidence in addition to information from consensus pricing services may be needed for management to support their valuation. In particular, this may be the case if the sources are providing indicative prices based on their own valuation techniques and management is unable to obtain an understanding of how these sources calculated their prices.

Brokers providing broker quotes


As brokers provide quotes only as an incidental service for their clients, quotes they provide differ in many respects from prices obtained in pricing services. Brokers may be unwilling to provide information about the process used to develop their quote, but may have access to information on transactions about which a pricing service may not be aware. Broker quotes may be executable or indicative. Indicative quotes are a broker’s best estimate of fair value, whereas an executable quote shows that the broker is willing to transact at this price. Executable quotes are strong evidence of fair value. Indicative quotes are less so because of the lack of transparency into the methods used by the broker to establish the quote. In addition the rigour of controls over the brokers’ quote often will differ depending on whether the broker also holds the same security in its own portfolio. Broker quotes are often used for securities with level 3 inputs and sometimes may be the only external information available.

Further considerations relating to third-party pricing sources


Understanding how the pricing sources calculated a price enables management to determine whether such information is suitable for use in its valuation, including as an input to a valuation technique and in what level of inputs the security should be categorised for disclosure purposes. For example, third-party pricing sources may value financial instruments using proprietary models, and it is important that management understands the methodology, assumptions and data used.


If fair value measurements obtained from third-party pricing sources are not based on the current prices of an active market, it will be necessary for management to evaluate whether the fair value measurements were derived in a manner that is consistent with the applicable financial reporting framework. Management’s understanding of the fair value measurement includes:

  • How the fair value measurement was determined―for example, whether the fair value measurement was determined by a valuation technique, in order to assess whether it is consistent with the fair value measurement objective;
  • Whether the quotes are indicative prices, indicative spread, or binding offers; and
  • How frequently the fair value measurement is estimated by the third-party pricing sources―in order to assess whether it reflects market conditions at the measurement date.


Understanding the bases on which third-party pricing sources have determined their quotes in the context of the particular financial instruments held by the entity assists management in evaluating the relevance and reliability of this evidence to support its valuations.


It is possible that there will be disparities between price indicators from different sources. Understanding how the price indicators were derived, and investigating these disparities, assists management in corroborating the evidence used in developing its valuation of financial instruments in order to evaluate whether the valuation is reasonable. Simply taking the average of the quotes provided, without doing further research, may not be appropriate, because one price in the range may be the most representative of fair value and this may not be the average. To evaluate whether its valuations of financial instruments are reasonable, management may:

  • Consider whether actual transactions represent forced transactions rather than transactions between willing buyers and willing sellers. This may invalidate the price as a comparison;
  • Analyse the expected future cash flows of the instrument. This could be performed as an indicator of the most relevant pricing data;
  • Depending on the nature of what is unobservable, extrapolate from observed prices to unobserved ones (for example, there may be observed prices for maturities up to ten years but not longer, but the ten year price curve may be capable of being extrapolated beyond ten years as an indicator). Care is needed to ensure that extrapolation is not carried so far beyond the observable curve that its link to observable prices becomes too tenuous to be reliable;
  • Compare prices within a portfolio of financial instruments to each other to make sure that they are consistent among similar financial instruments;
  • Use more than one model to corroborate the results from each one, having regard to the data and assumptions used in each; or
  • Evaluate movements in the prices for related hedging instruments and collateral.


In coming to its judgement as to its valuation, an entity may also consider other factors that may be specific to the entity’s circumstances.

Use of Valuation Experts


Management may engage a valuation expert from an investment bank, broker, or other valuation firm to value some or all of its securities. Unlike pricing services and broker quotes, generally the methodology and data used are more readily available to management when they have engaged an expert to perform a valuation on their behalf. Even though management has engaged an expert, management is ultimately responsible for the valuation used.

Issues Related to Financial Liabilities


Understanding the effect of credit risk is an important aspect of valuing both financial assets and financial liabilities. This valuation reflects the credit quality and financial strength of both the issuer and any credit support providers. In some financial reporting frameworks, including Australian Accounting Standards, the measurement of a financial liability assumes that it is transferred to a market participant at the measurement date. Where there is not an observable market price for a financial liability, its value is typically measured using the same method as a counterparty would use to measure the value of the corresponding asset, unless there are factors specific to the liability (such as third-party credit enhancement). In particular, the entity’s own credit risk[10] can often be difficult to measure.


An asset backed security is a financial instrument which is backed by a pool of underlying assets (known as the collateral, such as credit card receivables or vehicle loans) and derives value and income from those underlying assets.


Own credit risk is the amount of change in fair value that is not attributable to changes in market conditions.

Presentation and Disclosure about Financial Instruments


Most financial reporting frameworks, including Australian Accounting Standards, require disclosures in the financial report to enable users of the financial report to make meaningful assessments of the effects of the entity’s financial instrument activities, including the risks and uncertainties associated with financial instruments.


Most frameworks require the disclosure of quantitative and qualitative information (including accounting policies) relating to financial instruments. The accounting requirements for fair value measurements in financial statement presentation and disclosures are extensive in most financial reporting frameworks and encompass more than just valuation of the financial instruments. For example, qualitative disclosures about financial instruments provide important contextual information about the characteristics of the financial instruments and their future cash flows that may help inform investors about the risks to which entities are exposed.

Categories of Disclosures


Disclosure requirements include:

  1. Quantitative disclosures that are derived from the amounts included in the financial report―for example, categories of financial assets and liabilities;
  2. Quantitative disclosures that require significant judgement―for example, sensitivity analysis for each type of market risk to which the entity is exposed; and
  3. Qualitative disclosures―for example, those that describe the entity’s governance over financial instruments; objectives; controls, policies and processes for managing each type of risk arising from financial instruments; and the methods used to measure the risks.


The more sensitive the valuation is to movements in a particular variable, the more likely it is that disclosure will be necessary to indicate the uncertainties surrounding the valuation. Certain financial reporting frameworks, including Australian Accounting Standards, may also require disclosure of sensitivity analyses, including the effects of changes in assumptions used in the entity’s valuation techniques. For example, the additional disclosures required for financial instruments with fair value measurements that are categorised within level 3 inputs of the fair value hierarchy are aimed at informing users of financial report about the effects of those fair value measurements that use the most subjective inputs.


Some financial reporting frameworks, for example, Australian Accounting Standards, require disclosure of information that enables users of the financial report to evaluate the nature and extent of the risks arising from financial instruments to which the entity is exposed at the reporting date. This disclosure may be contained in the notes to the financial statements, or in management’s discussion and analysis within its annual report cross-referenced from the audited financial report. The extent of disclosure depends on the extent of the entity’s exposure to risks arising from financial instruments. This includes qualitative disclosures about:

  • The exposures to risk and how they arise, including the possible effects on an entity’s future liquidity and collateral requirements;
  • The entity’s objectives, policies and processes for managing the risk and the methods used to measure the risk; and
  • Any changes in exposures to risk or objectives, policies or processes for managing risk from the previous period.

Section II―Audit Considerations Relating to Financial Instruments

Includes: Professional Scepticism, Planning Considerations, Assessing and Responding to the Risks of Material Misstatement, Valuation of Financial Instruments


Certain factors may make auditing financial instruments particularly challenging. For example:

  • It may be difficult for both management and the auditor to understand the nature of financial instruments and what they are used for, and the risks to which the entity is exposed.
  • Market sentiment and liquidity can change quickly, placing pressure on management to manage their exposures effectively.
  • Evidence supporting valuation may be difficult to obtain.
  • Individual payments associated with certain financial instruments may be significant, which may increase the risk of misappropriation of assets.
  • The amounts recorded in the financial report relating to financial instruments may not be significant, but there may be significant risks and exposures associated with these financial instruments.
  • A few employees may exert significant influence on the entity’s financial instruments transactions, in particular where their compensation arrangements are tied to revenue from financial instruments, and there may be possible undue reliance on these individuals by others within the entity.


These factors may cause risks and relevant facts to be obscured, which may affect the auditor’s assessment of the risks of material misstatement, and latent risks can emerge rapidly, especially in adverse market conditions.

Professional Scepticism


[11]Professional scepticism is necessary to the critical assessment of audit evidence and assists the auditor in remaining alert for possible indications of management bias. This includes questioning contradictory audit evidence and the reliability of documents, responses to inquiries and other information obtained from management and those charged with governance. It also includes being alert to conditions that may indicate possible misstatement due to error or fraud and considering the sufficiency and appropriateness of audit evidence obtained in light of the circumstances.


Application of professional scepticism is required in all circumstances, and the need for professional scepticism increases with the complexity of financial instruments, for example with regard to:

  • Evaluating whether sufficient appropriate audit evidence has been obtained, which can be particularly challenging when models are used or in determining if markets are inactive.
  • Evaluating management’s judgements, and the potential for management bias, in applying the entity’s applicable financial reporting framework, in particular management’s choice of valuation techniques, use of assumptions in valuation techniques, and addressing circumstances in which the auditor’s judgements and management’s judgements differ.
  • Drawing conclusions based on the audit evidence obtained, for example assessing the reasonableness of valuations prepared by management’s experts and evaluating whether disclosures in the financial report achieve fair presentation.


See ASA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Australian Accounting Standards, paragraph 15.

Planning Considerations


[12]The auditor’s focus in planning the audit is particularly on:

  • Understanding the accounting and disclosure requirements;
  • Understanding the financial instruments to which the entity is exposed, and their purpose and risks;
  • Determining whether specialised skills and knowledge are needed in the audit;
  • Understanding and evaluating the system of internal control in light of the entity’s financial instrument transactions and the information systems that fall within the scope of the audit;
  • Understanding the nature, role and activities of the internal audit function;
  • Understanding management’s process for valuing financial instruments, including whether management has used an expert or a service organisation; and
  • Assessing and responding to the risk of material misstatement.


ASA 300 Planning an Audit of a Financial Report deals with the auditor’s responsibility to plan an audit of a financial report.

Understanding the Accounting and Disclosure Requirements


ASA 540 requires the auditor to obtain an understanding of the requirements of the applicable financial reporting framework relevant to accounting estimates, including related disclosures and any regulatory requirements.[13] The requirements of the applicable financial reporting framework regarding financial instruments may themselves be complex and require extensive disclosures. Reading this Guidance Statement is not a substitute for a full understanding of all the requirements of the applicable financial reporting framework. For example, Australian Accounting Standards require consideration of areas such as:

  • Hedge accounting;
  • Accounting for “Day 1” profits or losses;
  • Recognition and derecognition of financial instrument transactions;
  • Own credit risk; and
  • Risk transfer and derecognition, in particular where the entity has been involved in the origination and structuring of complex financial instruments.


See ASA 540, paragraph 8(a).

Understanding the Financial Instruments


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 to identify whether:

  • Important aspects of a transaction are missing or inaccurately recorded;
  • A valuation appears appropriate;
  • The risks inherent in them are fully understood and managed by the entity; and
  • The financial instruments are appropriately classified into current and non-current assets and liabilities.


Examples of matters that the auditor may consider when obtaining an understanding of the entity’s financial instruments include:

  • To which types of financial instruments the entity is exposed.
  • The use to which they are put.
  • Management’s and, where 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 where transactions are linked, the overall impact of the financial instrument transactions.
  • How they fit into the entity’s overall risk management strategy.


Inquiries of the internal audit function and the risk management function, if such functions exist, and discussions with those charged with governance may inform the auditor’s understanding.


In some cases, a contract, including a contract for a non-financial instrument may contain a derivative. Some financial reporting frameworks, including Australian Accounting Standards, 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.

Using Those with Specialised Skills and Knowledge in the Audit[14]


When such a person’s expertise is in auditing and accounting, regardless of whether the person is from within or external to the firm, this person is considered to be part of the engagement team and is subject to the requirements of ASA 220 Quality Control for an Audit of a Financial Report and Other Historical Financial Information. When such a person’s expertise is in a field other than accounting or auditing, such person is considered to be an auditor’s expert and the provisions of ASA 620 Using the Work of an Auditor’s Expert apply. ASA 620 explains that distinguishing between specialised areas of accounting or auditing, and expertise in another field, will be a matter of professional judgement, but notes the distinction may be made between expertise in methods of accounting for financial instruments (accounting and auditing expertise) and expertise in complex valuation techniques for financial instruments (expertise in a field other than accounting or auditing).


A key consideration in audits involving financial instruments, particularly complex financial instruments, is the competence of the auditor. ASA 220[15] requires the engagement partner to be satisfied that the engagement team, and any auditor’s experts who are not part of the engagement team, collectively have the appropriate competence and capabilities to perform the audit engagement in accordance with professional standards and applicable legal and regulatory requirements and to enable an auditor’s report that is appropriate in the circumstances to be issued. Further, relevant ethical requirements[16] require the auditor to determine whether acceptance of the engagement would create any threats to compliance with the fundamental principles, including the professional competence and due care. Paragraph 79 below provides examples of the types of matters that may be relevant to the auditor’s considerations in the context of financial instruments.


See ASA 220, paragraph 14.


See ASA 102 Compliance with Ethical Requirements when Performing Audits, Reviews and Other Assurance Engagements.


Accordingly, auditing financial instruments may require the involvement of one or more experts or specialists, for example, in the areas of:

  • Understanding the financial instruments used by the entity and their characteristics, including their level of complexity. Using specialised skills and knowledge may be needed in checking whether all aspects of the financial instrument and related considerations have been captured in the financial statements, and evaluating whether adequate disclosure in accordance with the applicable financial reporting framework has been made where disclosure of risks is required.
  • Understanding the applicable financial reporting framework, especially when there are areas known to be subject to differing interpretations, or practice is inconsistent or developing.
  • Understanding the legal, regulatory, and tax implications resulting from the financial instruments, including whether the contracts are enforceable by the entity (for example, reviewing the underlying contracts), may require specialised skills and knowledge.
  • Assessing the risks inherent in a financial instrument.
  • Assisting the engagement team gather evidence to support management’s valuations or to develop a point estimate or range, especially when fair value is determined by a complex model; when markets are inactive and data and assumptions are difficult to obtain; when unobservable inputs are used; or when management has used an expert.
  • Evaluating information technology controls, especially in entities with a high volume of financial instruments. In such entities information technology may be highly complex, for example when significant information about those financial instruments is transmitted, processed, maintained or accessed electronically. In addition, it may include relevant services provided by a service organisation.


The nature and use of particular types of financial instruments, the complexities associated with accounting requirements, and market conditions may lead to a need for the engagement team to consult[17] with other accounting and audit professionals, from within or outside the firm, with relevant technical accounting or auditing expertise and experience, taking into account factors such as:

  • The capabilities and competence of the engagement team, including the experience of the members of the engagement team.
  • The attributes of the financial instruments used by the entity.
  • The identification of unusual circumstances or risks in the engagement, as well as the need for professional judgement, particularly with respect to materiality and significant risks.
  • Market conditions.


ASA 220, paragraph 18(b), requires the engagement partner to be satisfied that members of the engagement team have undertaken appropriate consultation during the course of the engagement, both within the engagement team and between the engagement team and others at the appropriate level within or outside the firm.

Understanding Internal Control


ASA 315 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 analysing 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 determines 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. The Appendix describes controls that may exist in an entity that deals in a high volume of financial instrument transactions.

Understanding the Nature, Role and Activities of the Internal Audit Function


In many large entities, the internal audit function may perform work that enables senior management and those charged with governance to review and evaluate the entity’s controls relating to the use of financial instruments. The internal audit function may assist in identifying the risks of material misstatement due to fraud or error. However, the knowledge and skills required of an internal audit function to understand and perform procedures to provide assurance to management or those charged with governance on the entity’s use of financial instruments are generally quite different from those needed for other parts of the business. The extent to which the internal audit function has the knowledge and skill to cover, and has in fact covered, the entity’s financial instrument activities, as well as the competence and objectivity of the internal audit function, is a relevant consideration in the external auditor’s determination of whether the internal audit function is likely to be relevant to the overall audit strategy and audit plan.


Areas where the work of the internal audit function may be particularly relevant are:[18]

  • Developing a general overview of the extent of use of financial instruments;
  • Evaluating the appropriateness of policies and procedures and management’s compliance with them;
  • Evaluating the operating effectiveness of financial instrument control activities;
  • Evaluating systems relevant to financial instrument activities; and
  • Assessing whether new risks relating to financial instruments are identified, assessed and managed.


Work performed by functions such as the risk management function, model review functions, and product control, may also be relevant.

Understanding Management’s Methodology for Valuing Financial Instruments


Management’s responsibility for the preparation of the financial report includes applying the requirements of the applicable financial reporting framework to the valuation of financial instruments. ASA 540 requires the auditor to obtain an understanding of how management makes accounting estimates and the data on which accounting estimates are based.[19] Management’s approach to valuation also takes into account the selection of an appropriate valuation methodology and the level of the evidence expected to be available. To meet the objective of a fair value measurement, an entity develops a valuation methodology to measure the fair value of financial instruments that considers all relevant market information that is available. A thorough understanding of the financial instrument being valued allows an entity to identify and evaluate the relevant market information available about identical or similar instruments that should be incorporated into the valuation methodology.


See ASA 540, paragraph 8(c).

Assessing and Responding to the Risks of Material Misstatement

Overall Considerations Relating to Financial Instruments


ASA 540[20] explains that the degree of estimation uncertainty affects the risk of material misstatement of accounting estimates. The use of more complex financial instruments, such as those that have a high level of uncertainty and variability of future cash flows, may lead to an increased risk of material misstatement, particularly regarding valuation. Other matters affecting the risk of material misstatement include:

  • The volume of financial instruments to which the entity is exposed.
  • The terms of the financial instrument, including whether the financial instrument itself includes other financial instruments.
  • The nature of the financial instruments.


See ASA 540, paragraph 2.

Fraud Risk Factors[21]


See ASA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of a Financial Report for requirements and guidance dealing with fraud risk factors.


Incentives for fraudulent financial reporting by employees may exist where compensation schemes are dependent on returns made from the use of financial instruments. Understanding how an entity’s compensation policies interact with its risk appetite, and the incentives that this may create for its management and traders, may be important in assessing the risk of fraud.


Difficult financial market conditions may give rise to increased incentives for management or employees to engage in fraudulent financial reporting: to protect personal bonuses, to hide employee or management fraud or error, to avoid breaching regulatory, liquidity or borrowing limits or to avoid reporting losses. For example, at times of market instability, unexpected losses may arise from extreme fluctuations in market prices, from unanticipated weakness in asset prices, through trading misjudgements, or for other reasons. In addition, financing difficulties create pressures on management concerned about the solvency of the business.


Misappropriation of assets and fraudulent financial reporting may often involve override of controls that otherwise may appear to be operating effectively. This may include override of controls over data, assumptions and detailed process controls that allow losses and theft to be hidden. For example, difficult market conditions may increase pressure to conceal or offset trades as they attempt to recover losses.

Assessing the Risk of Material Misstatement


The auditor’s assessment of the identified risks at the assertion level in accordance with ASA 315 includes evaluating the design and implementation of internal control. It provides a basis for considering the appropriate audit approach for designing and performing further audit procedures in accordance with ASA 330, including both substantive procedures and tests of controls. The approach taken is influenced by the auditor’s understanding of internal control relevant to the audit, including the strength of the control environment and any risk management function, the size and complexity of the entity’s operations and whether the auditor’s assessment of the risks of material misstatement include an expectation that controls are operating effectively.


The auditor’s assessment of the risk of material misstatement at the assertion level may change during the course of the audit as additional information is obtained. Remaining alert during the audit, for example, when inspecting records or documents may assist the auditor in identifying arrangements or other information that may indicate the existence of financial instruments that management has not previously identified or disclosed to the auditor. Such records and documents may include, for example:

  • Minutes of meetings of those charged with governance; and
  • Specific invoices from, and correspondence with, the entity’s professional advisors.

Factors to Consider in Determining Whether, and to What Extent, to Test the Operating Effectiveness of Controls


An expectation that controls are operating effectively may be more common when dealing with a financial institution with well-established controls, and therefore controls testing may be an effective means of obtaining audit evidence. When an entity has a trading function, substantive tests alone may not provide sufficient appropriate audit evidence due to the volume of contracts and the different systems used. Tests of controls, however, will not be sufficient on their own as the auditor is required by ASA 330 to design and perform substantive procedures for each material class of transactions, account balance and disclosure.[22]


See ASA 330, paragraph 18.


Entities with a high volume of trading and use of financial instruments may have more sophisticated controls, and an effective risk management function, and therefore the auditor may be more likely to test controls in obtaining evidence about:

  • The occurrence, completeness, accuracy, and cut-off of the transactions; and
  • The existence, rights and obligations, and completeness of account balances.


In those entities with relatively few financial instrument transactions:

  • Management and those charged with governance may have only a limited understanding of financial instruments and how they affect the business;
  • The entity may only have a few different types of instruments with little or no interaction between them;
  • There is unlikely to be a complex control environment (for example, the controls described in the Appendix may not be in place at the entity);
  • Management may use pricing information from third-party pricing sources to value their instruments; and
  • Controls over the use of pricing information from third-party pricing sources may be less sophisticated.


When an entity has relatively few transactions involving financial instruments, it may be relatively easy for the auditor to obtain an understanding of the entity’s objectives for using the financial instruments and the characteristics of the instruments. In such circumstances, much of the audit evidence is likely to be substantive in nature, the auditor may perform the majority of the audit work at year-end, and third-party confirmations are likely to provide evidence in relation to the completeness, accuracy, and existence of the transactions.


In reaching a decision on the nature, timing and extent of testing of controls, the auditor may consider factors such as:

  • The nature, frequency and volume of financial instrument transactions;
  • The strength of controls, including whether controls are appropriately designed to respond to the risks associated with an entity’s volume of financial instrument transactions and whether there is a governance framework over the entity’s financial instrument activities;
  • The importance of particular controls to the overall control objectives and processes in place at the entity, including the sophistication of the information systems to support financial instrument transactions;
  • The monitoring of controls and identified deficiencies in control procedures;
  • The issues the controls are intended to address, for example, controls related to the exercise of judgements compared with controls over supporting data. Substantive tests are more likely to be effective than relying on controls related to the exercise of judgement;
  • The competency of those involved in the control activities, for example whether the entity has adequate capacity, including during periods of stress, and ability to establish and verify valuations for the financial instruments to which it is exposed;
  • The frequency of performance of these control activities;
  • The level of precision the controls are intended to achieve;
  • The evidence of performance of control activities; and
  • The timing of key financial instrument transactions, for example, whether they are close to the period end.

Substantive Procedures


Designing substantive procedures includes consideration of:

  • The use of analytical procedures[23] ―While analytical procedures undertaken by the auditor can be effective as risk assessment procedures to provide the auditor with information about an entity’s business, they may be less effective as substantive procedures when performed alone. This is because the complex interplay of the drivers of the valuation often masks any unusual trends that might arise.
  • Non-routine transactions―Many financial transactions are negotiated contracts between an entity and its counterparty (often known as “over the counter” or OTC.) To the extent that financial instrument transactions are not routine and outside an entity’s normal activities, a substantive audit approach may be the most effective means of achieving the planned audit objectives. In instances where financial instrument transactions are not undertaken routinely, the auditor’s responses to assessed risk, including designing and performing audit procedures, have regard to the entity’s possible lack of experience in this area.
  • Availability of evidence―For example, when the entity uses a third-party pricing source, evidence concerning the relevant financial statement assertions may not be available from the entity.
  • Procedures performed in other audit areas―Procedures performed in other financial statement areas may provide evidence about the completeness of financial instrument transactions. These procedures may include tests of subsequent cash receipts and payments, and the search for unrecorded liabilities.
  • Selection of items for testing―In some cases, the financial instrument portfolio will comprise instruments with varying complexity and risk. In such cases, judgemental sampling may be useful.


ASA 315, paragraph 6(b), requires the auditor to apply analytical procedures as risk assessment procedures to assist in assessing the risks of material misstatement in order to provide a basis for designing and implementing responses to the assessed risks. ASA 520 Analytical Procedures, paragraph 6, requires the auditor to use analytical procedures in forming an overall conclusion on the financial report. Analytical procedures may also be applied at other stages of the audit.


For example, in the case of an asset-backed security, in responding to the risks of material misstatement for such a security, the auditor may consider performing some of the following audit procedures:

  • Examining contractual documentation to understand the terms of the security, the underlying collateral and the rights of each class of security holder.
  • Enquiring about management’s process of estimating cash flows.
  • Evaluating the reasonableness of assumptions, such as prepayment rates, default rates and loss severities.
  • Obtaining an understanding of the method used to determine the cash flow waterfall.
  • Comparing the results of the fair value measurement with the valuations of other securities with similar underlying collateral and terms.
  • Reperforming calculations.

Dual-Purpose Tests


Although the purpose of a test of controls is different from the purpose of a test of details, it may be efficient to perform both at the same time by, for example:

  • Performing a test of controls and a test of details on the same transaction (for example, testing whether a signed contract has been maintained and whether the details of the financial instrument have been appropriately captured in a summary sheet; or
  • Testing controls when testing management’s process of making valuation estimates.

Timing of the Auditor’s Procedures[24]


Paragraphs 11–12 and 22–23 of ASA 330 establish requirements when the auditor performs procedures at an interim period and explains how such audit evidence can be used.


After assessing the risks associated with financial instruments, the engagement team determines the timing of planned tests of controls and substantive audit procedures. The timing of planned audit procedures varies depending on a number of factors, including the frequency of the control operation, the significance of the activity being controlled, and the related risk of material misstatement.


While it is necessary to undertake most of the audit procedures in relation to valuation and presentation at the period end, audit procedures in relation to other assertions such as completeness and existence can usefully be tested at an interim period. For example tests of controls may be performed at an interim period for more routine controls, such as IT controls and authorisations for new products. Also, it may be effective to test the operating effectiveness of controls over new product approval by gathering evidence of the appropriate level of management sign-off on a new financial instrument for an interim period.


Auditors may perform some tests on models as of an interim date, for example, by comparing the output of the model to market transactions. Another possible interim procedure for instruments with observable inputs is to test the reasonableness of the pricing information provided by a third-party pricing source.


Areas of more significant judgement are often tested close to, or at, the period end as:

  • Valuations can change significantly in a short period of time, making it difficult to compare and reconcile interim balances with comparable information at the balance sheet date;
  • An entity may engage in an increased volume of financial instrument transactions between an interim period and year-end;
  • Manual journal entries may only be made after the end of the accounting period; and
  • Non-routine or significant transactions may take place late in the accounting period.

Procedures Relating to Completeness, Accuracy, Existence, Occurrence and Rights and Obligations


Many of the auditor’s procedures can be used to address a number of assertions. For example, procedures to address the existence of an account balance at period end will also address the occurrence of a class of transactions, and may also assist in establishing proper cut-off. This is because financial instruments arise from legal contracts and, by verifying the accuracy of the recording of the transaction, the auditor can also verify its existence, and obtain evidence to support the occurrence and rights and obligations assertions at the same time, and confirm that transactions are recorded in the correct accounting period.


Procedures that may provide audit evidence to support the completeness, accuracy, and existence assertions include:

  • External confirmation of bank accounts, trades, and custodian statements. This can be done by direct confirmation with the counterparty (including the use of bank confirmations), where a reply is sent to the auditor directly. Alternatively this information may be obtained from the counterparty’s systems through a data feed. Where this is done, controls to prevent tampering with the computer systems through which the information is transmitted may be considered by the auditor in evaluating the reliability of the evidence from the confirmation. If confirmations are not received, the auditor may be able to obtain evidence by reviewing contracts and testing relevant controls. External confirmations, however, often do not provide adequate audit evidence with respect to the valuation assertion though they may assist in identifying any side agreements.
  • Reviewing reconciliations of statements or data feeds from custodians with the entity’s own records. This may necessitate evaluating IT controls around and within automated reconciliation processes and to evaluate whether reconciling items are properly understood and resolved.
  • Reviewing journal entries and the controls over the recording of such entries. This may assist in, for example:
    • Determining if entries have been made by employees other than those authorised to do so.
    • Identifying unusual or inappropriate end-of-period journal entries, which may be relevant to fraud risk.
  • Reading individual contracts and reviewing supporting documentation of the entity’s financial instrument transactions, including accounting records, thereby verifying existence and rights and obligations. For example, an auditor may read individual contracts associated with financial instruments and review supporting documentation, including the accounting entries made when the contract was initially recorded, and may also subsequently review accounting entries made for valuation purposes. Doing so allows the auditor to evaluate whether the complexities inherent in a transaction have been fully identified and reflected in the accounts. Legal arrangements and their associated risks need to be considered by those with suitable expertise to ensure that rights exist.
  • Testing controls, for example by reperforming controls.
  • Reviewing the entity’s complaints management systems. Unrecorded transactions may result in the entity’s failure to make a cash payment to a counterparty, and may be detected by reviewing complaints received.
  • Reviewing master netting arrangements to identify unrecorded instruments.


These procedures are particularly important for some financial instruments, such as derivatives or guarantees. This is because they may not have a large initial investment, meaning it may be hard to identify their existence. For example, embedded derivatives are often contained in contracts for non-financial instruments which may not be included in confirmation procedures.

Valuation of Financial Instruments

Financial Reporting Requirements


Fair presentation financial reporting frameworks often use fair value hierarchies, for example those used in Australian Accounting Standards. This usually means that the volume and detail of the required disclosures increases as the level of measurement uncertainty increases. The distinction between the levels in the hierarchy may require judgement.


The auditor may find it useful to obtain an understanding of how the financial instruments relate to the fair value hierarchy. Ordinarily, the risk of material misstatement, and the level of audit procedures to be applied, increases as the level of measurement uncertainty increases. The use of level 3, and some level 2, inputs from the fair value hierarchy may be a useful guide to the level of measurement uncertainty. Level 2 inputs vary from those which are easily obtained to those which are closer to level 3 inputs. The auditor evaluates available evidence and understands both the fair value hierarchy and the risk of management bias in management’s categorisation of financial instruments in the fair value hierarchy.


In accordance with ASA 540,[26] the auditor considers the entity’s valuation policies and methodology for data and assumptions used in the valuation methodology. In many cases, the applicable financial reporting framework does not prescribe the valuation methodology. When this is the case, matters that may be relevant to the auditor’s understanding of how management values financial instruments include, for example:

  • Whether management has a formal valuation policy and, if so, whether the valuation technique used for a financial instrument is appropriately documented in accordance with that policy;
  • Which models may give rise to the greatest risk of material misstatement;
  • How management considered the complexity of the valuation of the financial instrument when selecting a particular valuation technique;
  • Whether there is a greater risk of material misstatement because management has internally developed a model to be used to value financial instruments or is departing from a valuation technique commonly used to value the particular financial instrument;
  • Whether management made use of a third-party pricing source;
  • Whether those involved in developing and applying the valuation technique have the appropriate skills and expertise to do so, including whether a management’s expert has been used; and
  • Whether there are indicators of management bias in selecting the valuation technique to be used.


See ASA 540, paragraph 8(c).

Assessing the Risk of Material Misstatement Related to Valuation


When evaluating whether the valuation techniques used by an entity are appropriate in the circumstances, and whether controls over valuation techniques are in place, the factors considered by the auditor may include:

  • Whether the valuation techniques are commonly used by other market participants and have been previously demonstrated to provide a reliable estimate of prices obtained from market transactions;
  • Whether the valuation techniques operate as intended and there are no flaws in their design, particularly under extreme conditions, and whether they have been objectively validated. Indicators of flaws include inconsistent movements relative to benchmarks;
  • Whether the valuation techniques take account of the risks inherent in the financial instrument being valued, including counterparty creditworthiness, and own credit risk in the case of valuation techniques used to measure financial liabilities;
  • How the valuation techniques are calibrated to the market, including the sensitivity of the valuation techniques to changes in variables;
  • Whether market variables and assumptions are used consistently and whether new conditions justify a change in the valuation techniques, market variables or assumptions used;
  • Whether sensitivity analyses indicate that valuations would change significantly with only small or moderate changes in assumptions;
  • The organisational structure, such as the existence of an internal department responsible for developing models to value certain instruments, particularly where level 3 inputs are involved. For example, a model development function that is involved in assisting in pricing deals is less objective than one which is functionally and organisationally segregated from the front office; and
  • The competence and objectivity of those responsible for the development and application of the valuation techniques, including management’s relative experience with particular models that may be newly developed.


The auditor (or auditor’s expert) may also independently develop one or more valuation techniques to compare its output with that of the valuation techniques used by management.

Significant Risks


The auditor’s risk assessment process may lead the auditor to identify one or more significant risks relating to the valuation of financial instruments, when any of the following circumstances exist:

  • High measurement uncertainty related to the valuation of financial instruments (for example, those with unobservable inputs).[27]
  • Lack of sufficient evidence to support management’s valuation of its financial instruments.
  • Lack of management understanding of its financial instruments or expertise necessary to value such instruments properly, including the ability to determine whether valuation adjustments are needed.
  • Lack of management understanding of complex requirements in the applicable financial reporting framework relating to measurement and disclosure of financial instruments, and inability of management to make the judgements required to properly apply those requirements.
  • The significance of valuation adjustments made to valuation technique outputs when the applicable financial reporting framework requires or permits such adjustments.


Where the auditor determines that the high estimation uncertainty related to the valuation of complex financial instruments gives rise to a significant risk, ASA 540 requires the auditor to perform substantive procedures and evaluate the adequacy of the disclosure of their estimation uncertainty. See ASA 540, paragraphs 11, 15 and 20.


For accounting estimates that give rise to significant risks, in addition to other substantive procedures performed to meet the requirements of ASA 330, ASA 540[28] requires the auditor to evaluate the following:

  1. How management has considered alternative assumptions or outcomes, and why it has rejected them, or how management has otherwise addressed measurement uncertainty in making the accounting estimate;
  2. Whether the significant assumptions used by management are reasonable; and
  3. Where relevant to the reasonableness of the significant assumptions used by management, or the appropriate application of the applicable financial reporting framework, management’s intent to carry out specific courses of action and its ability to do so.


See ASA 540, paragraph 15(a)-(b).


As markets become inactive, the change in circumstances may lead to a move from valuation by market price to valuation by model, or may result in a change from one particular model to another. Reacting to changes in market conditions may be difficult if management does not have policies in place prior to their occurrence. Management may also not possess the expertise necessary to develop a model on an urgent basis, or select the valuation technique that may be appropriate in the circumstances. Even where valuation techniques have been consistently used, there is a need for management to examine the continuing appropriateness of the valuation techniques and assumptions used for determining valuation of financial instruments. Further, valuation techniques may have been selected in times where reasonable market information was available, but may not provide reasonable valuations in times of unanticipated stress.

Presentation and Disclosure of Financial Instruments

Includes: Procedures Relating to the Presentation and Disclosure of Financial Instruments


Management’s responsibilities include the preparation of the financial report in accordance with the applicable financial reporting framework. Financial reporting frameworks, including Australian Accounting Standards, often require disclosures in the financial report to enable users of the financial report to make meaningful assessments of the effects of the entity’s financial instrument activities, including the risks and uncertainties associated with these financial instruments. The importance of disclosures regarding the basis of measurement increases as the measurement uncertainty of the financial instruments increases and is also affected by the level of the fair value hierarchy.


In representing that the financial report is in accordance with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding the presentation and disclosure of the various elements of financial statements and related disclosures. Assertions about presentation and disclosure encompass:


Occurrence and rights and obligations—disclosed events, transactions, and other matters have occurred and pertain to the entity.


Completeness—all disclosures that should have been included in the financial report have been included.


Classification and understandability—financial information is appropriately presented and described, and disclosures are clearly expressed.


Accuracy and valuation—financial and other information are disclosed fairly and at appropriate amounts.


The auditor’s procedures around auditing disclosures are designed in consideration of these assertions.

Procedures Relating to the Presentation and Disclosure of Financial Instruments


In relation to the presentation and disclosures of financial instruments, areas of particular importance include:

Financial reporting frameworks generally require additional disclosures regarding estimates, and related risks and uncertainties, to supplement and explain assets, liabilities, income, and expenses. The auditor’s focus may need to be on the disclosures relating to risks and sensitivity analysis. Information obtained during the auditor’s risk assessment procedures and testing of control activities may provide evidence in order for the auditor to conclude about whether the disclosures in the financial report are in accordance with the requirements of the applicable financial reporting framework, for example about:

The entity’s objectives and strategies for using financial instruments, including the entity’s stated accounting policies;

The entity’s control framework for managing its risks associated with financial instruments; and

The risks and uncertainties associated with the financial instruments.

Information may come from systems outside traditional financial reporting systems, such as risk systems. Examples of procedures that the auditor may choose to perform in responding to assessed risks relative to disclosures include testing:

The process used to derive the disclosed information; and

The operating effectiveness of the controls over the data used in the preparation of disclosures.

In relation to financial instruments having significant risk, even where the disclosures are in accordance with the applicable financial reporting framework, the auditor may conclude that the disclosure of estimation uncertainty is inadequate in light of the circumstances and facts involved and, accordingly, the financial report may not achieve fair presentation. ASA 705 provides guidance on the implications for the auditor’s opinion when the auditor believes that management’s disclosures in the financial report are inadequate or misleading.

Auditors may also consider whether the disclosures are complete and understandable, for example, all relevant information may be included in the financial report (or accompanying reports) but it may be insufficiently drawn together to enable users of the financial report to obtain an understanding of the position or there may not be enough qualitative disclosure to give context to the amounts recorded in the financial statements. For example, even when an entity has included sensitivity analysis disclosures, the disclosure may not fully describe the risks and uncertainties that may arise because of changes in valuation, possible effects on debt covenants, collateral requirements, and the entity’s liquidity. ASA 260 contains requirements and guidance about communicating with those charged with governance, including the auditor’s views about significant qualitative aspects of the entity’s accounting practices, including accounting policies, accounting estimates and financial statement disclosures.


Consideration of the appropriateness of presentation, for example on short-term and long-term classification, in substantive testing of financial instruments is relevant to the auditor’s evaluation of the presentation and disclosure.

Other Relevant Audit Considerations

Includes: Written Representations, Communication with Those Charged with Governance and Others, Communications with Regulators and Others

Written Representations


ASA 540 requires the auditor to obtain written representations from management and, where appropriate, those charged with governance whether they believe significant assumptions used in making accounting estimates are reasonable. ASA 580 requires that if, in addition to such required representations, the auditor determines that it is necessary to obtain one or more written representations to support other audit evidence relevant to the financial report or one or more specific assertions in the financial report, the auditor shall request such other written representations. Depending on the volume and degree of complexity of financial instrument activities, written representations to support other evidence obtained about financial instruments may also include:

Management’s objectives with respect to financial instruments, for example, whether they are used for hedging, asset/liability management or investment purposes;

Representations about the appropriateness of presentation of the financial report, for example the recording of financial instrument transactions as sales or financing transactions;

Representations about the financial statements and note disclosures concerning financial instruments, for example that:

The records reflect all financial instrument transactions; and

All embedded derivative instruments have been identified;

Whether all transactions have been conducted at arm’s length and at market value;

The terms of transactions;

The appropriateness of the valuations of financial instruments;

Whether there are any side agreements associated with any financial instruments;

Whether the entity has entered into any written options;

Management’s intent and ability to carry out certain actions; and

Whether subsequent events require adjustment to the valuations and disclosures included in the financial report.

Communication with Those Charged with Governance and Others


Because of the uncertainties associated with the valuation of financial instruments, the potential effects on the financial report of any significant risks are likely to be of governance interest. The auditor may communicate the nature and consequences of significant assumptions used in fair value measurements, the degree of subjectivity involved in the development of the assumptions, and the relative materiality of the items being measured at fair value to the financial report as a whole. In addition, the need for appropriate controls over commitments to enter into financial instrument contracts and over the subsequent measurement processes are matters that may give rise to the need for communication with those charged with governance.


ASA 260 deals with the auditor’s responsibility to communicate with those charged with governance in an audit of a financial report. With respect to financial instruments, matters to be communicated to those charged with governance may include:

A lack of management understanding of the nature or extent of the financial instrument activities or the risks associated with such activities;

Significant deficiencies in the design or operation of the systems of internal control or risk management relating to the entity’s financial instrument activities that the auditor has identified during the audit;

Significant difficulties encountered when obtaining sufficient appropriate audit evidence relating to valuations performed by management or a management’s expert, for example, where management is unable to obtain an understanding of the valuation methodology, assumptions and data used by the management’s experts, and such information is not made available to the auditor by management’ s expert;

Significant differences in judgements between the auditor and management or a management’s expert regarding valuations;

The potential effects on the entity’s financial report of material risks and exposures required to be disclosed in the financial report, including the measurement uncertainty associated with financial instruments;

The auditor’s views about the appropriateness of the selection of accounting policies and presentation of financial instrument transactions in the financial report;

The auditor’s views about the qualitative aspects of the entity’s accounting practices and financial reporting for financial instruments; or

A lack of comprehensive and clearly stated policies for the purchase, sale and holding of financial instruments, including operational controls, procedures for designating financial instruments as hedges, and monitoring exposures.


The appropriate timing for communications will vary with the circumstances of the engagement; however, it may be appropriate to communicate significant difficulties encountered during the audit as soon as practicable if those charged with governance are able to assist the auditor to overcome the difficulty, or if it is likely to lead to a modified opinion.

Communications with Regulators and Others


In some cases, auditors may be required, or may consider it appropriate, to communicate directly with regulators or prudential supervisors, in addition to those charged with governance, regarding matters relating to financial instruments. Such communication may be useful throughout the audit. For example, in some jurisdictions, banking regulators seek to cooperate with auditors to share information about the operation and application of controls over financial instrument activities, challenges in valuing financial instruments in inactive markets, and compliance with regulations. This coordination may be helpful to the auditor in identifying risks of material misstatement.

aus 0.4

Aus . The prudential supervisor in Australia for financial institutions is the Australian Prudential Regulation Authority (APRA). Prudential standards issued by APRA cover communications between the auditor and APRA. See, for example, APS 310 Audit and Related Matters, GPS 310 Audit and Actuarial Reporting and Valuation and LPS 310 Audit and Actuarial Requirements.

Conformity with International Pronouncements

Includes: Examples of Controls Relating to Financial Instruments

This Guidance Statement conforms with International Auditing Practice Note (IAPN) 1000 Special Considerations in Auditing Financial Instruments issued by the International Auditing and Assurance Standards Board (IAASB), an independent standard-setting board of the International Federation of Accountants (IFAC).

Paragraphs that have been added to this Guidance Statement (and do not appear in the text of the equivalent IAPN) are identified with the prefix “Aus”.


Examples of Controls Relating to Financial Instruments

The following 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. Further information on the use of trade confirmations and clearing houses is contained in paragraphs 25–26 of this Guidance Statement.

As in any 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.

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