[Alex]

Hi everyone,

When studying for audit I encountered the following MC:

Auditors may need to plan and perform auditing procedures for financial statement assertions about derivatives and hedging activities. Which of the following substantive procedures most clearly tests the completeness assertion about derivatives?
A. Requesting counterparties to provide information about them, such as whether side agreements have been made.
B. Assessing the reasonableness of the use of an option-pricing model.
C. Determining whether changes in the fair value of derivatives designated and qualifying as hedging instruments have been reported in earnings or in other comprehensive income.
D. Physically inspecting the derivative contract.

The answer is A. But I don’t understand why confirming with the counterparty would provide assurance that the derivative contract is properly recorded by the auditee? The way I see it, this only provides assurance about the existence of the derivative contract.

Can someone help please. Thanks!!

[jakemikey777]

Hey Alex, that's a very good question. It's easier for me because I'm doing audit currently, I'm assuming you work in industry?

To get to it, and also as a high level overview, the general rule of thumb is the directional risk for liabilities is completeness (you want to make sure you are not understating liabilities) and for assets you are worried about existence and valuation (you want to make sure what the company is reporting is actually there and valued accurately, hence the need for testing reserves, etc.).

You make a good point; however, note the slight wording they snuck in, “Side agreements”, which imply there may be agreements that would lead to additional derivatives which the auditor was previously was aware of, or heck even the client is unaware of. Thus, you are making sure everything is complete. Had the answer simply been “Requesting counterparties to provide information about the curerent derivatives” or something to that effect, it would have been wrong.

B) is wrong because you are testing valuation and accuracy, C) is also wrong because you are once again worried with valuation, accuracy, and classification (disclosures). D) Could be correct, that would be the second best answer in this situation but A) is more correct because you are verifying additional information with 3rd parties.

Lastly, as a general rule of thumb and this might not be the best example but just as a general example for liabilities one common test that auditor's do is to inspect the board of director meeting minutes. The idea is there may be information discussed there which could give rise to a liability (you can't test what's not there, thus completeness is a risk as discussed with liabilities).

Hope that helps.

[Alex]

Thank you so much Jake!!

It makes a lot of sense now. I wasn't sure what ‘side agreements' were, and I thought there was no correct answer for this one.

I'm going to work in audit as well, just graduated from a Macc program 🙂

[Author]

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