08 Auditing Financial Instruments

EurofirmHedge Funds training*Auditing Financial InstrumentsSeptember 2007

*connectedthinking

PricewaterhouseCoopersSeptember 2007

Why are we here?

Investment banks and dealers develop new products egweather 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


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


PwC Practice Aid - A Framework for Auditing FinancialInstruments



Issued on 8 November 2006 and available on the GlobalKnowledge Curve

Contents

How to use the framework

Limitations

Audit Approach

Risks and Controls

Substantive Tests of Details

Evaluating the clients estimate of fair value



Contents (continued)

Use of Valuation Specialists

Impact of valuation issues on the audit report

Appendix 1 Illustrative Control proceduresfor Auditing the Valuation Assertion


Limitations of the Framework

Deals with auditing fair values of financialinstruments

Was developed before FAS 157

Fund of Funds should follow AU 332 guidanceand practice aids


A Framework for Auditing Financial InstrumentsAudit Approach (Section 3.1)


A Framework for Auditing Financial InstrumentsHeat Map (Section 3.2)


A Framework for Auditing Financial InstrumentsHeat Map Inputs Methodology

Heat Map breaks valuation down into two key parts1- 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


A Framework for Auditing Financial InstrumentsRisks and Controls

Understanding of the Business, and Nature of FinancialInstruments Used

- Is this a new business or a core / ancillarybusiness?

- Does the client have the necessaryinfrastructure to execute, process and accountfor these transactions?

Expertise of client

- Derivatives (exchange-traded, plain vanilla over-the-counter or highly customized products)?

- Equity products (exchange-traded versusinterests in private vehicles, such as privateequity funds)?

- Debt instruments (plain-vanilla versus structuredproducts with embedded derivatives)?

Complexity of thevaluation of theseinstrumentsUse the Heat Map (see Section 3)to make this assessment

- Completeness?

- Volume of transactions (one-off transactionversus frequent buys and sells)?

Population of financialinstruments



Understanding of the Business, and Nature of FinancialInstruments 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 forentering into thesetransactions



Evaluation of Company Level Controls (CLSs) (Section 4.1.3)

Evaluate the effectiveness of the CLCs, because these controlshave a pervasive impact on controls at the process, transactionor application level (See PwC Audit 4170: Company-LevelControls).

CLCs that we intend to rely on must be validated

Policies & Procedures

New Product / Transaction Approval Process

Risk Oversight & Reporting

Model Governance

ITGCs


A Framework for Auditing Financial InstrumentsValuation Controls

Price validation and verification are key controls due to theilliquidity of instruments and modelling challenges at many funds.

Governance around determination and review of fair valuesis a key aspect of the valuation process.

Other Pricing Considerations

Model Control Change control

An inventory of potential controls that might be applicable forfinancial instruments in each box of the Heat Map may be foundin the Framework section 4.2.3


Auditing Financial InstrumentsRisk GovernanceKey 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



After considering these factors, engagement teams should be ina position to identify likely Key Risks.

Key Risks: Those conditions or factors within an audit that, inthe judgement of the auditor, give rise to a greater risk ofmaterial financial misstatement or other matters resulting in theissuance of an inappropriate audit report

We often identify too many risks as Key Risks.

Validation of controls

Consult PwC valuation specialists where appropriate.


Auditing Financial InstrumentsSummary


A Framework for Auditing Financial InstrumentsSubstantive 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 applicablefor financial instruments in each box of the Heat Map may befound in the Framework section 5.2.1 / 5.2.2


Auditing Financial InstrumentsUse of Broker Quotes

Discuss with client the process by which appropriate sources areidentified. Understand if the client has a process in place tovalidate the appropriateness of sources by reviewing transactionaldata, etc. Consider reviewing transactional data to corroborate theappropriateness of a source, especially for large positions forwhich few quotes may be available.

3. Validate appropriatenessof source

Who is providing the quote? Is the firm a market-maker in thesecurity? Does their business include the type of securities forwhich they are providing a quote? Were they the original counter-party to the transaction? Who within the firm is providing thequote? What department are they in? Is this consistent acrossperiods?

2. Know your source

Consider performing additional procedures to the extent only onequote is obtained. Such procedures can include, but are not limitedto, obtaining a valuation memo from the client explaining theposition, the appropriateness of the single source and the reasonswhy additional sources may not be available or appropriate.

1. More is betterCommentsConsiderations



Is the client marking to an outlier? How does the client identify ifthe quote is an outlier in the case of multiple quotes? If the client ismarking to a quote which may appear to be an outlier, we shouldunderstand their rationale and obtain supporting/corroboratingaudit evidence. This may require discussion with valuationspecialists.

5. Review for outliers

Document our consideration of the various disclaimers that mayaccompany the quotes received. Understand why the client iscomfortable using these quotes and document accordingly.

4. Consider disclaimersCommentsConsiderations



Does the footnote disclosure adequately reflect the use of brokerquotes as a valuation source? Consider fair value disclosureimplications.

7. Review footnotedisclosure

Compare year-end mark to actual transactions before and afteryear-end to assess reasonableness of quotes. Consider reviewingclient's back testing (to the extent performed) or comparingtransactions during year to closest mark to assess reasonablenessof marks during the year.

6. Review actualtransactions

CommentsConsiderations


Assessing Clients Determination of fair value


A Framework for Auditing Financial InstrumentsUse of Valuation Specialists

When & Where to User Specialists (Section 7.3)

The decision to engage specialists or experts in the audit isthe responsibility of the engagement leader. Considerationshould begin early in the engagement cycle, either during theAcceptance & Continuance process or during mobilization,but the need for specialists or experts can arise at any timeduring the audit.

Section 7.4 given examples of areas where engagement teamsmay consider using a specialist

Section 7.6 deals with notes and responsibilities when usingspecialists/experts


A Framework for Auditing Financial InstrumentsUse 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


Auditing Financial InstrumentsImpact of Valuation issues on Audit Report

More Complex the instrument the greater the inherentuncertainty in managements estimated fair value

Section 8 of the framework gives guidance on emphasis ofmatter paragraphs and fair valuation paragraphs

Current Auditing standards have removed the mandatoryrequirement for explanatory paragraph where materialuncertainties exist SAS 79 US GAAS and ISA 620

If there are significant amounts fair valued by managementengagement teams may consider including a fair valuationparagraph consultation is required with Risk managementpartner.


Summary


Summary

Consider the Valuation Framework guidance and use it inplanning your audit approach

Pay particular attention to using the heat map (section 2)in theaudit planning process, assessing differences in fair valueestimates (section 6) and the use of specialists, if required.

Re-visit the funds valuation policy disclosures to ensure theyare complete and tailored appropriately ensure they fullycomply with accounting requirements (SOP 94-6 disclosure ofcertain significant risks and uncertainties, IAS 32/39 and IFRS7 on Financial Instruments)

Use of Broker Quotes

2007 PricewaterhouseCoopers. All rights reserved. "PricewaterhouseCoopers" refers toPricewaterhouseCoopers or, as the context requires, the PricewaterhouseCoopers global network or other memberfirms of the network, each of which is a separate and independent legal entity. PricewaterhouseCoopers, OneSpencer Dock, North Wall Quay, Dublin 1 is authorised by the Institute of Chartered Accountants in Ireland to carryon investment business. Designed by PwC Design Studio (00873)

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08 Auditing Financial Instruments

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