2014 Year-End Audits: Expectations & Controls

As many of you prepare for year-end audits, we would like to share our expectations on where auditors will focus, and highlight key controls in a derivative environment.

To uncover audit direction and focus, we looked to the 2014 PCAOB findings (available here) related to their reviews of 2013 audits performed by the Big 4.

Our review of the Big 4 PCAOB investigations indicated that this year:

• There were no findings related to special hedge accounting;
• only one firm had findings related specifically to derivatives, and;
• all four firms had numerous comments around fair value concepts.

As a result, we expect to see quite a bit of audit interest around derivative fair values and reviews of related controls. Continuing the theme from last year, there seems to be an emphasis on controls related to fair values provided by third parties or specialists, and an expectation that management maintain control and a sufficiently deep understanding of the inputs and assumptions related to valuations.

A nuance this year was the PCAOB detailing their expectation of “segregation of duties between those committing the entity to the transactions and those responsible for undertaking the valuations.” This control weakness often appears in corporate trading environments where limited valuation expertise exists outside the Treasury group; such a situation often results in derivative journal entries being prepared by Treasury (often by the individual executing the trades), then forwarded to and “booked” by accounting. The PCAOB pressure on audit firms will be increasing the scrutiny of these controls. To be prepared, we encourage all accounting organizations to access valuation training and take ownership of derivative valuations, journal entries and disclosures.

If your company is using derivatives, we remind you that the fundamental control issues you must address are:

• Do I have all derivatives identified?
• Are they on my balance sheet at fair value?

For those taking special accounting treatment, there is an additional key control dependent on whether the hedge is a cash flow, fair value or net investment hedge.

• Cash flow hedgers need to ensure that the amount booked to OCI is appropriate (supported by appropriate hedge documentation, effectiveness testing and probability), and that the timing of amounts reclassed out of OCI is following the third-party transaction supporting the hedge, rather than following cash.
• Fair value hedgers need to ensure that the hedged transaction meets the FASB definition of a firm commitment and that the appropriate change in the hedged item is captured in the balance sheet and subsequently reclassified to earnings.
• Net investment hedgers need to ensure that they are re-designating their hedges at least quarterly with the appropriate proportion of the hedged entity (or entities) designated.

Additionally, disclosures should be addressing all derivatives opened, open and/or closed in the period: Realized and unrealized gains and losses are subject to disclosure requirements.

Finally, if you are a CapellaFX user, it is useful to note that the software is designed to make it simple to provide auditors with the information they need for recalculations.