Question 4: Case study on Financial Instruments and Fair Value

You are auditing the financial instruments for a financial institution in Australia. While their primary business has been foreign exchange (trading and exchanging in foreign currencies), they have also entered recently (within the last 3 years) into a full range of derivatives, including hedging contracts for foreign exchange currencies and a range of other derivatives including options, swaps and futures contracts (all in relation to foreign exchange). Management engaged external experts to assist in developing the derivative trading strategy, as they have some knowledge, but not extensive knowledge of the risks and processes associated with derivative trading, so they have retained the external experts to assist in regular reviews of derivative policies and practices within the team. The foreign exchange derivatives trading team has good knowledge of the products they sell, and they have sub-divided the team into their focus area: one group focuses on hedging, one group on options and swaps and another on futures. They have been given significant leeway under policy by the company, as management rely on the processes established by the external consultant. Management is aware that there has been a history (especially in international banks} of foreign exchange traders taking ever greater risks and over-exposing their organisations.

In your substantive testing, you identify three different types of discrepancies: The settlement amounts for a series of transactions have been entered incorrectly (the effect of this is understate the risk carried to the organization) The contract dates for many derivatives are entered incorrectly. There are some discrepancies with respect to cash received for derivatives sold. Receipts are not issued immediately and physical cash is only deposited once a week. Management have actual little oversight of the team and almost no oversight over actual contracts entered into and exposure.

Required: Evaluate the evidence you have obtained in relation to policy and valuation. Identify any risks or ‘red flags’ in relation to the potential for material misstatement that you consider important in your role as an auditor. Suggest what actions you think you would need to undertake based on your evaluation.