Auditing Financial Instruments | Auditing and Attestation | CPA Exam

IN this session, I will discuss auditing financial instrument.
✔️Accounting students and CPA Exam candidates, check my website for additional resources: https://farhatlectures.com/
📧Connect with me on social media: https://linktr.ee/farhatlectures

#cpaexam #accountingstudent #auditcourse



Design and perform audit tests of financial instruments accounts.

In testing the year-end balance of financial instruments, the auditor must accumulate sufficient appropriate evidence to evaluate whether the financial instruments accounts, as stated on the balance sheet, are fairly stated and properly disclosed in accordance with all eight balance-related audit objectives used for tests of details of balances (existence, completeness, accuracy, classification, cutoff, detail tie-in, realizable value, and rights).
Business risks associated with financial instruments will vary depending on the significance and aggressiveness of a company’s investing activity. Risks will be higher for companies investing in less liquid securities or derivative financial instruments, and when investments represent a greater proportion of total assets. Financial services firms are exposed to greater risk due to the sheer volume of activity and types of instruments traded.
The financial instruments account balances may be material depending on the type and frequency of investment activity. Factors that impact inherent risk of financial instruments include management’s objectives related to investment activity (e.g., hedging to minimize risk), the complexity of the securities or derivatives, the company’s prior experience with certain investments, and whether external factors such as credit risk or interest rate risk impact the relevant assertions. Many of these risks relate to the accuracy, classification, and realizable value audit objectives. An additional factor that increases inherent risk for financial instruments is the complexity of the relevant accounting standards. The majority of financial instruments are valued using fair value estimates. Accounting standards distinguish between a level 1 fair value estimate (observable, i.e., quoted, prices in an active market for identical assets or liabilities) and level 2 or level 3 estimates. Level 2 estimates use observable inputs (directly or indirectly) other than quoted prices, such as a price for a similar asset or liability, whereas level 3 estimates use unobservable inputs such as a pricing model or discounted cash flows.
\The auditor needs to have an understanding of the design and operating effectiveness of internal controls surrounding the initiation, authorization, processing, fair value measurement, and disclosure of investment activities. Most importantly, management needs to have (1) an investment strategy and an awareness of the level of exposure to various risks; (2) procedures in place to properly classify financial instruments as trading, available-for-sale, or held-to-maturity based on intent; (3) procedures in place to initiate and record transactions; and (4) strong internal controls over determining fair value estimates, such as personnel with appropriate expertise or experience in valuing level 2 or 3 estimates.
Unlike some other accounts where an auditor can choose to perform more extensive substantive testing and reduce reliance on controls, assessing internal controls related to financial instruments may be necessary in order to reduce audit risk to an acceptable level, especially for transaction-related audit objectives. Tests of transactions to be performed related to financial instruments include tests of purchases and sales of securities and derivatives or settling of hedging transactions, associated gains or losses, and interest and dividend income.
Substantive analytical procedures are typically not as important in assessing the year-end balance for financial instruments because these balances may fluctuate from year-to-year and are not necessarily linked to other accounts. However, substantive analytical procedures may be used to test the reasonableness of interest and dividend income. Auditors may also compare the relative percentage of investments in each of the three fair value categories (level 1, 2, or 3) from year-to-year to assess changes in investment strategy or portfolio risk.
The starting point for testing the ending balance of financial instrument accounts is to obtain a schedule of investment activity for the year. A schedule of investment activity will include beginning balances, purchases and sales of financial instruments as well as the associated gains or losses, and ending balances recorded at fair market value or other value consistent with accounting standards. The