Eurofirm

Hedge Funds training*

Auditing Financial Instruments
September 2007
*connectedthinking
Slide 2 PricewaterhouseCoopers
September 2007
Why are we here?
Investment banks and dealers develop new products eg
weather derivatives, carbon credits
Hedge Funds looking for new ways to generate returns
Recent Market Events
- Release of FAS 157
- Valuation of hedge fund assets has become a key business
and regulatory issue in the industry.
- Sub prime issues in the US and impact on other markets also
Audit Requirements
Quality and Consistency
Need to Consult
Slide 3 PricewaterhouseCoopers
September 2007
Points of Focus
Understand the business drivers
Develop an inventory of investments
Understand the financial instruments that the fund invests in
Control Environment
- Tone at the top
- Management expertise
- Risk management
- Valuation policies and supporting documentation
Materiality
Understand the relevant assertions where we need comfort
Slide 4 PricewaterhouseCoopers
September 2007
PwC Practice Aid - A Framework for Auditing Financial
Instruments
Slide 5 PricewaterhouseCoopers
September 2007
PwC Practice Aid - A Framework for Auditing Financial
Instruments
Issued on 8 November 2006 and available on the Global
Knowledge Curve
Contents
How to use the framework
Limitations
Audit Approach
Risks and Controls
Substantive Tests of Details
Evaluating the clients estimate of fair value
Slide 6 PricewaterhouseCoopers
September 2007
PwC Practice Aid - A Framework for Auditing Financial
Instruments
Contents (continued)
Use of Valuation Specialists
Impact of valuation issues on the audit report
Appendix 1 Illustrative Control procedures
for Auditing the Valuation Assertion
Slide 7 PricewaterhouseCoopers
September 2007
Limitations of the Framework
Deals with auditing fair values of financial
instruments
Was developed before FAS 157
Fund of Funds should follow AU 332 guidance
and practice aids
Slide 8 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Audit Approach (Section 3.1)
Slide 9 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Heat Map (Section 3.2)
Slide 10 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Heat Map (Section 3.2)
Slide 11 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Heat Map Inputs Methodology
Heat Map breaks valuation down into two key parts
1- Availability of Inputs: Four Types (Section 3.3.1)
- Readily Available
- Discoverable and Objective
- Discoverable and Subjective
- Derivable or Unobservable
- Note: FAS 157 has less options
2- Pricing Methodology: Three Types (Section 3.3.2)
- Standard and Objective
- Standard but Subjective
- Non-Standard
Slide 12 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Risks and Controls
Understanding of the Business, and Nature of Financial
Instruments Used
- Is this a new business or a core / ancillary
business?
- Does the client have the necessary
infrastructure to execute, process and account
for these transactions?
Expertise of client
- Derivatives (exchange-traded, plain vanilla over-
the-counter or highly customized products)?
- Equity products (exchange-traded versus
interests in private vehicles, such as private
equity funds)?
- Debt instruments (plain-vanilla versus structured
products with embedded derivatives)?
Complexity of the
valuation of these
instruments
Use the Heat Map (see Section 3)
to make this assessment
- Completeness?
- Volume of transactions (one-off transaction
versus frequent buys and sells)?
Population of financial
instruments
Slide 13 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Risks and Controls
Understanding of the Business, and Nature of Financial
Instruments Used (continued)
- What can go wrong?
Risks
- Investment purposes- Speculative / trading?
- Risk management / hedging (interest rate risk,
credit risk, foreign exchange risk, prices)?
Business reasons for
entering into these
transactions
Slide 14 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Risks and Controls
Evaluation of Company Level Controls (CLSs) (Section 4.1.3)
Evaluate the effectiveness of the CLCs, because these controls
have a pervasive impact on controls at the process, transaction
or application level (See PwC Audit 4170: Company-Level
Controls).
CLCs that we intend to rely on must be validated
Policies & Procedures
New Product / Transaction Approval Process
Risk Oversight & Reporting
Model Governance
ITGCs
Slide 15 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Valuation Controls
Price validation and verification are key controls due to the
illiquidity of instruments and modelling challenges at many funds.
Governance around determination and review of fair values
is a key aspect of the valuation process.
Other Pricing Considerations
Model Control Change control
An inventory of potential controls that might be applicable for
financial instruments in each box of the Heat Map may be found
in the Framework section 4.2.3
Slide 16 PricewaterhouseCoopers
September 2007
Auditing Financial Instruments
Risk Governance
Key Challenge: How to ensure Risk Management has teeth
Aspects of risk governance include:
- Segregation of duties and defined roles and responsibilities
- Defined processes for determination of risk appetite consistent
with disclosures
- Escalation of risk issues and reporting to management
- Risk Committee independence
Evidence of risk involvement in decision making including:
Establishing risk appetite
Strategy / transaction approval
Due diligence on external managers
Risk Measures
Slide 17 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Risks and Controls
After considering these factors, engagement teams should be in
a position to identify likely Key Risks.
Key Risks: Those conditions or factors within an audit that, in
the judgement of the auditor, give rise to a greater risk of
material financial misstatement or other matters resulting in the
issuance of an inappropriate audit report
We often identify too many risks as Key Risks.
Validation of controls
Consult PwC valuation specialists where appropriate.
Slide 18 PricewaterhouseCoopers
September 2007
Auditing Financial Instruments
Summary
Slide 19 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Substantive Tests of Details (Section 5)
Some examples are:
Use of IMSAG and investigation of any differences
Use of a PwC valuation specialist
Confirmation of investments
- Confirmation of value with a counterparty
- Confirmation of broker quotes
Review of contracts (for derivatives)
An inventory of potential tests of details that might be applicable
for financial instruments in each box of the Heat Map may be
found in the Framework section 5.2.1 / 5.2.2
Slide 20 PricewaterhouseCoopers
September 2007
Auditing Financial Instruments
Use of Broker Quotes
Discuss with client the process by which appropriate sources are
identified. Understand if the client has a process in place to
validate the appropriateness of sources by reviewing transactional
data, etc. Consider reviewing transactional data to corroborate the
appropriateness of a source, especially for large positions for
which few quotes may be available.
3. Validate appropriateness
of source
Who is providing the quote? Is the firm a market-maker in the
security? Does their business include the type of securities for
which they are providing a quote? Were they the original counter-
party to the transaction? Who within the firm is providing the
quote? What department are they in? Is this consistent across
periods?
2. Know your source
Consider performing additional procedures to the extent only one
quote is obtained. Such procedures can include, but are not limited
to, obtaining a valuation memo from the client explaining the
position, the appropriateness of the single source and the reasons
why additional sources may not be available or appropriate.
1. More is better
Comments Considerations
Slide 21 PricewaterhouseCoopers
September 2007
Auditing Financial Instruments
Use of Broker Quotes
Is the client marking to an outlier? How does the client identify if
the quote is an outlier in the case of multiple quotes? If the client is
marking to a quote which may appear to be an outlier, we should
understand their rationale and obtain supporting/corroborating
audit evidence. This may require discussion with valuation
specialists.
5. Review for outliers
Document our consideration of the various disclaimers that may
accompany the quotes received. Understand why the client is
comfortable using these quotes and document accordingly.
4. Consider disclaimers
Comments Considerations
Slide 22 PricewaterhouseCoopers
September 2007
Auditing Financial Instruments
Use of Broker Quotes
Does the footnote disclosure adequately reflect the use of broker
quotes as a valuation source? Consider fair value disclosure
implications.
7. Review footnote
disclosure
Compare year-end mark to actual transactions before and after
year-end to assess reasonableness of quotes. Consider reviewing
client's back testing (to the extent performed) or comparing
transactions during year to closest mark to assess reasonableness
of marks during the year.
6. Review actual
transactions
Comments Considerations
Slide 23 PricewaterhouseCoopers
September 2007
Assessing Clients Determination of fair value
Slide 24 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Use of Valuation Specialists
When & Where to User Specialists (Section 7.3)
The decision to engage specialists or experts in the audit is
the responsibility of the engagement leader. Consideration
should begin early in the engagement cycle, either during the
Acceptance & Continuance process or during mobilization,
but the need for specialists or experts can arise at any time
during the audit.
Section 7.4 given examples of areas where engagement teams
may consider using a specialist
Section 7.6 deals with notes and responsibilities when using
specialists/experts
Slide 25 PricewaterhouseCoopers
September 2007
A Framework for Auditing Financial Instruments
Use of Valuation Specialists
When & Where to User Specialists (Section 7.3) (continued)
Best Practices (Section 7.7)
Set objectives/goals early in the process
Agree upon an anticipated budget and timing
Set scope / approach
Slide 26 PricewaterhouseCoopers
September 2007
Auditing Financial Instruments
Impact of Valuation issues on Audit Report
More Complex the instrument the greater the inherent
uncertainty in managements estimated fair value
Section 8 of the framework gives guidance on emphasis of
matter paragraphs and fair valuation paragraphs
Current Auditing standards have removed the mandatory
requirement for explanatory paragraph where material
uncertainties exist SAS 79 US GAAS and ISA 620
If there are significant amounts fair valued by management
engagement teams may consider including a fair valuation
paragraph consultation is required with Risk management
partner.
Slide 27 PricewaterhouseCoopers
September 2007
Summary
Slide 28 PricewaterhouseCoopers
September 2007
Summary
Consider the Valuation Framework guidance and use it in
planning your audit approach
Pay particular attention to using the heat map (section 2)in the
audit planning process, assessing differences in fair value
estimates (section 6) and the use of specialists, if required.
Re-visit the funds valuation policy disclosures to ensure they
are complete and tailored appropriately ensure they fully
comply with accounting requirements (SOP 94-6 disclosure of
certain significant risks and uncertainties, IAS 32/39 and IFRS
7 on Financial Instruments)
Use of Broker Quotes
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