Practice Note 23: auditing complex financial instruments (revised)

Comments from ACCA to the Financial Reporting Council (FRC), March 2009.

ACCA welcomes the opportunity to comment on the above Practice Note (proposed PN 23). We present our general comments in the body of this letter and attach an appendix containing suggestions made in relation to specific paragraphs of the text. In the main, we conclude that proposed PN 23 is well drafted and continues to be of considerable value.

We commend the APB for its decision to extend the scope of proposed PN 23 from just derivatives to all complex financial instruments (CFI). The timing of this revision is particularly helpful in the current economic circumstances.

Changes resulting from the Clarity project of the International Auditing and Assurance Standards Board

As noted in the preface to proposed PN 23, it has been aligned with the APB's International Standards on Auditing (ISAs) (UK and Ireland). The APB has recently announced that it intends to update those standards with effect for audits of financial statements for periods ending after 14 December 2010. It will be necessary to update proposed PN 23, and indeed others in the PN series, to accord with the changed ISAs (UK and Ireland). Ideally, such revisions should occur in parallel with their commencement, but if APB resources do not permit that, we encourage the APB to consult stakeholders on the priority to be given to revising each PN.

As we first suggested in our response to proposed PN 11 The audit of charities in the United Kingdom (Revised), we encourage the APB to widen such a consultation to include the nature of industry guidance and the form of publications, such as PNs and Bulletins. Such a consultation could usefully encompass appropriate responses to the increasingly Internet-based availability of legislation, regulation and authoritative accounting guidance direct from Government and regulatory bodies.

Structure of proposed PN 23

As indicted above, under the heading 'Changes resulting from the Clarity project of the International Auditing and Assurance Standards Board' we believe that there is scope for improvement to, inter alia, the structure of proposed PN 23.

The order of the document essentially parallels key aspects of the audit process, from planning to reporting and communication, which is a sensible approach. However, the proposed PN repeats certain requirements from the ISAs (UK and Ireland) without enough modification to demonstrate adequately how the auditor considers applying a particular requirement to the audit of CFI. We suggest that this duplication is unnecessary and, as it is selective, it introduces possible confusion as to the emphasis on requirements that are not mentioned.

The material on considerations when financial market conditions are difficult is presented in a separate section. That makes it difficult for the auditor to integrate the guidance which is primarily relevant to the identification of risks and the selection of appropriate means of obtaining evidence.

Integration would also facilitate reference to material that can be relevant when a specific market becomes inactive in circumstances other than general financial market difficulties.

Service organisations are addressed at the beginning of the section 'Understanding of the entity and its environment' but it is not clear how this section should be applied when carrying out the risk assessment and when gathering audit evidence. We suggest that the material ought to be better integrated.

Inherent limitations in the audit of complex financial instruments 

The risk that an auditor will not identify a material misstatement arising from CFI is higher than in many other aspects of an audit. In the absence of a specific auditing standard, there is a strong argument, therefore, that proposed PN 23 ought to state that the inherent limitations of an audit are particularly significant in the case of fraud or error relating to CFI. There is an unavoidable risk that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with auditing standards.

Because of the above, proposed PN 23 should give sufficient guidance for auditors to use it as a reference document for their work in relation to the completeness of identification of CFI activities. This could be achieved by providing sufficient examples of the ways in which CFI are used to achieve operating and financing objectives.

Special considerations in the audit of smaller entities 

CFI may feature in the audit of smaller entities and while PN 23 is, therefore, equally applicable to smaller entities, there is only one place within it where the guidance refers specifically to related special considerations (paragraph 25, '...where an entity is too small to achieve proper segregation of duties...'). We suggest that more could be done to provide targeted guidance, particularly as for such entities, financial instruments are likely to be less-frequently encountered and so individually more difficult to manage at any particular level of complexity. Indeed, for smaller entities, guidance may be appropriate for financial instruments that might not otherwise be regarded as 'complex'. It would be helpful if proposed PN 23 could include an explicit statement that its guidance may be relevant for smaller entities. That would go some way to countering the impression that it is not.

Paragraph 16 makes the point that complexity may arise if a simple financial instrument is used in a complex situation. There is an argument, therefore, that the title and scope of proposed PN 23 ought to be changed to refer to and explain 'complexity arising from the use of financial instruments'. This would also promote reference to the document by auditors seeking guidance on relatively simple financial instruments.

Estimation uncertainty

Proposed PN 23 refers to uncertainty in the estimation of valuation, but only to:

  • State a requirement to disclose (paragraph 97)
  • Relate the nature and reliability of information to the degree of uncertainty (paragraph 110)
  • Relate the degree of uncertainty to the risks of material misstatement (paragraph 110) 

We suggest that, because of its considerable importance, it would be worth drawing on the practical experience of auditors to provide further guidance on the circumstances of, and response to, significant estimation uncertainty.


References below are to specific paragraphs of proposed PN 23.

Paragraphs 12 and 13

We are concerned that, taken together, paragraphs 12 and 13 could lead auditors to believe that they ought to elaborate on the scope of the audit set out in the engagement letter by making specific reference to the approach to CFI. We find the reference to materiality (last sentence of paragraph 12) inappropriate in a section dealing with responsibility and suggest that it be deleted, thereby removing duplication of some of the material in paragraph 72.

Paragraphs 15 to 17

Paragraph 15 includes a list of matters on which an understanding is obtained but, in contrast to paragraph 16, does not suggest that any are of especial significance to the decision as to whether special skills and knowledge may be needed. It would be more helpful to follow the approach in paragraph 16 as otherwise the need for special skills and knowledge is overemphasised. Similarly, paragraph 17, overemphasises the importance of market conditions, which are just one aspect that can change from one audit to the next. Change itself can be a source of complexity (in its wider sense).

We suggest that this section is rewritten so as to present, in an organised list, the factors that are particularly relevant to the need for special skills and knowledge in relation to CFI. These factors should not generally extend to valuations by quoted market price and computer applications, the latter being considered on many audits.

Paragraph 19

Paragraph 19, which deals with engagement quality control review, gives the impression that such a review would be appropriate as the presence of complex financial instruments would lead to 'the identification of unusual circumstances or risks in the engagement'. This is unlikely to be the case for a smaller entity as the absolute level of public interest in its audit is normally at a very low level. Indeed, many smaller auditors would not need to carry out any engagement quality control reviews.

Paragraph 30

Accounting requirements are referred to in paragraph 30 in a way that suggests that management always applies the relevant standards. We suggest that auditors need to consider firstly whether an entity applies UK or international standards and, if the former, whether in respect of recognition and measurement, it applies FRS 26.

Paragraph 55

The second sentence of paragraph 55 is ambiguous. We suggest that it should refer explicitly to the knowledge and skills required of an internal audit function. Alternatively, the paragraph could be completely rewritten to clarify its prose and eliminate repetition.

Paragraph 56

We have commented in the body of our letter on the fact that internal audit will not be present in many smaller audits and suggest, therefore, that paragraph 56 should not, in effect, prejudge the use of that function.

In finalising proposed PN 23, we assume the APB will have regard to the outcome of its consultation paper Revised Draft Ethical Standards for Auditors in respect of where personnel from internal auditing assist the external auditor.

Paragraph 61

Although paragraph 61 provides one example of a fraud risk factor relating to CFI, we suggest that it should also address the risk of fraud through unwarranted backdating of the designation of a financial asset or liability under applicable account standards. While this is mentioned in the fraud risk paragraphs under the heading 'Considerations when financial market conditions are difficult' , it is not confined to such market conditions. See also our comments on the structure of proposed PN 23.

Paragraph 105

There is a danger that paragraph 105 could be interpreted as suggesting that management representations ought to be obtained for all the items listed where CFI activity is of significant volume or complexity. The presence of other evidence, for example transaction documentation, will render many of these representations unnecessary and the guidance ought to highlight, therefore, those matters where management representation is vital.

Last updated: 11 Apr 2012