Derivatives: what's an auditor to do?

Hardly a day goes by without a derivatives disaster being reported in the business press-the spectacular loss by Barings PLC is just one of several recent examples (exhibit 1, page 77, lists others). It is, however, not news that derivatives markets have experienced tremendous growth in recent years. Derivatives use-and the associated problems-are not confined to the financial services industry. All types of entities in all industries, from manufacturing to retail to not-for-profit organizations to pension funds, use derivative financial instruments. Nor is their use limited to large corporations. This wide use of derivatives is underscored by recent reported losses by end-users-often to the apparent surprise of the board of directors and senior management.

In the finger pointing that has followed derivatives losses, questions have been directed to auditors as to the extent of their review of controls and testing of transactions. This article addresses the question of what derivatives are and why auditors should be concerned about them. Auditors must understand what the term refers to and why there has been explosive growth in derivatives use. It then should be clear that the audit implications are significant for all entities engaging in derivatives transactions.

DERIVATIVES

Derivatives cover a broad range of financial instruments that "derive" their value from other financial instruments, underlying assets or indices (see JofA, Mar.95, page 55). They include listed futures and options, forwards, currency and interest rate swaps and various combinations of these instruments. End-users such as commercial or industrial companies may employ derivatives for purposes such as hedging raw materials costs, capping borrowing costs, locking in a U.S. dollar price on foreign export sales or simply speculating, thereby enhancing (or harming) earnings.

Auditors should be mindful of a number of derivatives characteristics:

* Off-balance-sheet nature. Since derivatives contracts often are entered into with little or no cash changing hands, the amounts on an entity's trial balance may not indicate the full extent of its involvement. Moreover, without the necessary controls for recording changes in value, significant unrecorded gains and losses can

* Complexity. Derivatives contracts often are highly structured to an end-user's particular needs. As a result, it is not always clear how a particular instrument is being used, how it should be valued and accounted for and whether it is achieving the desired economic objectives. An entity may misunderstand the actual terms and effects of a particular derivatives contract, resulting in potential problems and embarrassment when the confusion comes to light.

* Leverage. Financial engineers have created new opportunities to further magnify the already significant leverage derivatives represent. For example, a so-called leveraged interest rate swap may require interest payments that are- a multiple of changes in a specified market rate-sharply exposing an entity to potential losses disproportionate to interest rate changes.

* Illiquidity. In some cases derivatives markets may be illiquid, creating problems both in valuing instruments and in exiting or unwinding positions.

* Unclear accounting and tax rules. These rules generally have not kept pace with the rapid development of new derivatives products and uses. In fact, product designers often try to take advantage of existing anomalies.

* Legal risk. Some entities have been unable to enforce the terms of derivatives contracts against a counterparty -such as a government agency or a company in a regulated industry-that does not have the authority to enter into the transaction or lacks adequate or clear documentation of contract terms. Enforceability risks are heightened with foreign counterparties and may not come to light until the counterparty's credit deteriorates or bankruptcy or insolvency occurs.

* Operational and control risk. A company's treasury department often originates derivatives transactions, sometimes without coordinating them with those responsible for recording the transaction and the financial and tax reporting.

BASIC AUDIT OBJECTIVES

A thoughtful reading of the above list, while sobering, should lead auditors to focus on basic audit objectives that are no different from those they would apply to other areas: existence or occurrence, completeness, rights and obligations, valuation or allocation and presentation and disclosure. Here are some general guidelines on derivatives to consider in the various stages of a typical audit:

Planning. The starting point should be gaining a thorough understanding of a client's use of derivatives (see exhibit 2, page 79). Auditors should focus on identifying the nature and extent of an entity's involvement, including the types of financial instruments used and the intended purposes. To do this, the auditor must be sufficiently involved with operational areas outside the financial reporting group, most notably the treasury function, but possibly other areas as well.

During the planning phase of an engagement, auditors also must make a preliminary assessment of management controls over derivatives activities. This will provide a basis for determining the nature and degree of testing of such controls, with the goal of determining the extent to which the controls can be relied on. Some of the key controls that should be present, including both high-level and more detailed controls, include

* Authorization of the entity's derivatives program by senior management and the board or an appropriate board committee, such as audit or finance.

* Policies and procedures to limit and monitor the extent of market and credit risk assumed in derivatives transactions. An entity should clearly define which instruments are to be used for particular purposes, the extent and limit of their uses and the authorized counterparties with whom the entity may enter into derivatives transactions. Systems and reporting mechanisms should be established to detect, report and act on violations of such limits as well as on changes in the counterparties' credit status.

* Policies and procedures to reduce credit risk on transactions by obtaining adequate collateral, third-party guarantees or letters of credit, for example, and by using master netting agreements with counterparties.

* Appropriate monitoring controls to ensure transactions are reviewed for compliance with established policies, are properly authorized and are accurately recorded.

* Proper segregation of duties between those originating derivatives transactions and those approving and recording them by having, for example, transaction confirmations from counterparties received by someone independent of the originator.

* Procedures to measure and monitor the results of derivatives transactions against objectives. Normally this requires an entity to properly value or "mark to market" outstanding derivatives transactions. There also should be procedures for monitoring the accuracy of such valuation techniques, including controls over any computer models employed. When more complex derivatives and hedging techniques are used, entities should consider performing sensitivity analyses and stress tests against a full range of potential market movements.

* Periodic review by internal audit or some other group, with prompt action on the results of these reviews.

* Establishment of clear accounting and tax policies for derivatives use and procedures to ensure proper recording of transactions in accordance with these policies. When hedge accounting is employed, such transactions should be properly designated as hedges and should comply with other relevant criteria specified in applicable accounting and tax rules and regulations.

Tests of controls. As with any other audit area, auditors should perform tests of controls to determine the degree of reliance that can be placed on the internal control system as a basis for reducing substantive testing. While specific tests will vary from entity to entity depending on the types of transactions and the nature of the control systems, some typical tests of controls over derivatives activities might include those of

* Compliance with approved policies, such as whether the entity adhered to established market and credit risk limits, the reporting of any instances in which such limits were exceeded and whether appropriate remedial action was taken.

* Individual transaction authorizations, including evidence of approval by a responsible official independent of the transaction originator.

* Completeness of recording of transactions, including the functioning of specific controls over capturing trades and review of periodic reconciliations of trade activity and related balances. Auditors also should consider confirming the details of a sample of transactions directly with the counterparties involved.

* Valuation procedures employed by the entity. This includes a review of any internal valuation models, sample comparison of valuations produced by these models with independent outside valuation sources (quoted prices for exchange-traded options and futures, dealer quotes for currency and interest rate swaps and pricing services and possibly valuation specialists for unique and highly structured derivatives), testing of inputs (such as yield curves for currency and interest rate swaps and volatilities for options) to the internal models against current market data and testing of the consistency of the values ascribed by the company's models by the use of selected test transactions or by reference to actual sale or purchase transactions.

* The proper classification of transactions for accounting and tax purposes. Because these rules are complex and still evolving, the appropriate treatment may not always be clear. For example, certain transactions, while functioning as an economic hedge, may not qualify for hedge accounting. Similarly, certain transactions may be viewed as speculative for tax purposes, resulting in capital gain or loss treatment. Auditors should review and test the procedures in place to appropriately identify and address these issues.

* Procedures for authorizing new counterparties, for obtaining collateral or guarantees, letters of credit and master netting agreements and for monitoring counterparties' credit status.

The Committee of Sponsoring Organizations of the Treadway Commission is addressing the application of its work, Internal Control-integrated Framework, to this area by developing a guide, Internal Control-Derivatives, which is expected to be released this year.

Substantive tests. Given the complexity of individual derivatives transactions and the large dollar amounts often associated with them, it is not surprising auditors often choose to rely heavily on substantive tests to satisfy their audit objectives. Typical tests include

* Confirming with counterparties outstanding transactions as of the balance sheet date.

* Reviewing individual transaction terms by reference to contracts or trade tickets.

* Verifying yearend valuations and reconciliation of profit and loss balances.

* Reviewing credit risk and exposure related to counterparties and the establishment of appropriate credit reserves, if warranted.

* Reviewing tax attributes of derivatives transactions in conjunction with overall tax accrual audit procedures.

FINANCIAL STATEMENT

CONSIDERATIONS

In addition to the above audit procedures, the evolving nature of financial reporting and disclosure for derivatives, as well as the heightened focus by financial statement users on derivatives, places a burden on auditors to properly focus on presentation and disclosure issues. Key issues for auditors to assess include

* Proper use of hedge accounting in accordance with applicable Financial Accounting Standards Board pronouncements, Emerging Issues Task Force consensuses and other relevant guidance.

* Appropriate disclosure of accounting policies adopted.

* Appropriateness of disclosures of information required by FASB Statement no. 105, Disclosure of Information about Financial Instruments with Off-balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, Statement no. 107, Disclosures about Fair Values of Financial Instruments, and Statement no. 119, Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments, which significantly expands the required disclosures.

* For Securities and Exchange Commission registrants, a review of additional footnote disclosures and management's discussion and analysis. Last year, the SEC formed a derivatives task force and sent comment letters to hundreds of registrants requesting additional detailed disclosures and commentary about derivatives activities and the effects on a company's reported results, financial position and liquidity.

OTHER PROCEDURES AND

CONSIDERATIONS

Depending on the significance of a client's derivatives activities, auditors should consider supplementing the above procedures with appropriate representations from client senior management and communication with both senior management and the board or appropriate board committees, such as audit or finance.

Representation about derivatives activities should be included in the overall client representation letter, with specific separate letters from individuals, if appropriate. It should reveal to the auditor all known transactions, appropriate characterization of hedges and proper valuation of derivatives for financial statement presentation and disclosure.

Given the attention paid to derivatives transactions by analysts, the business press, the SEC and other regulators, this topic has been an agenda item this past year at virtually every public company audit committee or board meeting. There is a growing expectation that external auditors will provide insights into a company's control over, derivatives and the appropriateness of its financial reporting and disclosures of these activities as well as a candid assessment of the company's derivatives profile. Heavy derivatives activity, complex transactions, aggressive accounting, weak controls or limited disclosures obligate auditors to discuss the details and implications of these matters with the board or audit committee.

HERE TO STAY

Derivatives are not a passing fad, but an integral element in corporate risk management for the 1990s and beyond. Thus, auditors must approach derivatives not as a narrowly focused supplement to the audit plan, but as an ongoing and integral part of the audit process. We hope the, procedures and considerations described here will provide a basic framework for addressing this important and timely subject.

EXECUTIVE SUMMARY

* AS DERIVATIVES LOSSES BECOME more common, it's important for auditors to understand derivatives and the significant audit implications for entities that use them. Derivatives use-and losses-are not limited to large corporations. * DERIVATIVES REPRESENT a broad range of financial instruments that derive their value from other instruments, including futures and options, forwards, currency and interest rate swaps and various kinds of combinations. * AUDITORS SHOULD UNDERSTAND the characteristics of derivatives that may have an impact on how the audit of an entity that uses them will be conducted. Characteristics that auditors will need to consider include their off-balance-sheet nature, their complexity, the leverage involved, their illiquidity, the absence of clear accounting and tax rules, the legal risks and the operational and control risks. * WHEN PLANNING AN AUDIT, auditors need a clear understanding of how an entity uses derivatives. It also will be necessary to test the entity's internal control system to determine its reliability with regard to derivatives transactions. * AUDITORS ALSO MUST FOCUS ON financial statement presentation issues to ensure statement users have a clear idea of how an entity uses derivatives and to satisfy all of the reporting requirements for public companies.

EXHIBIT I

Derivatives-related losses

Barings PLC. $1 billion loss resulting in the company's collapse. The loss resulted from unauthorized trading in Nikkei index future

Metallgesellschaft. $1 billion loss related to the use of energy futures and other derivatives that were hedges of future fixed-price sales commitments.

Piper Jaffrey. $700 million loss in mutual funds from investments in interest rate derivatives.

Kidder Peabody. $350 million "phantom" profit related to trading in so-called government strips.

Proctor & Gamble. $157 million loss on closeout of leveraged interest rate swaps.

Cargill. $90 million loss in value of mortgage-backed derivatives

Investors Equity Life insurance Company of Hawaii. $90 million loss resulting from trading in treasury bond futures.

Air Products & Chemical. $60 million loss in value of leveraged interest rate swaps due to increased interest rates.

Harris Trust and Sayings Bank. $51 million loss in investments in collateralized mortgage obligation derivatives.

EXHIBIT 2

Derivatives: Key questions for auditors

1. What is the extent and nature of the entity's use of derivatives? What instruments are used, for what purposes, how often and in what notional-contract amounts? 2. Have senior management and the board of directors (or a committee of the board) authorized the use of derivatives and key aspects of the program? 3. Have detailed written policies and procedures covering the use of derivatives been developed? 4. Are there appropriate monitoring controls to ensure that transactions are properly authorized, comply with established policies and limits and are accurately recorded? S. Is there proper segregation of duties between those originating derivatives transactions and those responsible for approving and recording them? 6. Does the entity have policies and procedures to adequately control credit risk with counterparties? 7. How does the entity monitor and review the results of its derivatives programs against objectives? 8. Have clear accounting and tax policies been established for derivatives use, and do these policies comply with applicable rule*s and regulations? 9. Has derivatives activity been subject to periodic internal audits? If so, what have the results been? 10. Has derivatives activity been properly reflected, disclosed and discussed in the financial statements, annual report and Securities and Exchange Commission and other regulatory filings in accordance with applicable generally accepted accounting principles, SEC and regulatory requirements?

BARRY N. WINOGRAD, CPA, is a partner in the national business assurance directorate of Coopers & Lybrand, LLP, New York City, where he is the director of business assurance services. He is a member of the American Institute of CPAs special committee on financial reporting and of the New York State Society of CPAs. ROBERT H. HERZ, CPA, is associate national director of accounting and SEC services and a partner in the national business assurance directorate of Coopers & Lybrand, New York City. A member of the FASB financial instruments task force and the AICPA SEC regulations committee, he also is a member of the New York and Massachusetts CPA societies and of the Institute of Chartered Accountants in England and Wales.