PwC supports the proposed IAPS and its practical guidance given the prevalence of fair value accounting and the global economic environment, which continues to present challenges in the valuation of complex financial instruments and disclosures about risk and uncertainties. PwC supports the detailed audit considerations guidance in the proposed IAPS and believes that it will provide a useful source of guidance for those auditors with less experience in auditing complex financial instruments. PwC believes that there are some areas in the draft which interpret requirements and guidance in the ISAs in a manner that the firm is not convinced is appropriate, and could result in unnecessary work effort in some circumstances or may be impracticable.
For the attention of Mr James Gunn
International Auditing and Assurance Standards Board
545 Fifth Avenue, 14th Floor
New York, New York, 10017
11 February 2011
IAASB Exposure Draft - IAPS 1000, ‘Special Considerations in Auditing Complex Financial Instruments’ and ‘Proposals relating to International Auditing Practice Statements (IAPSs)’
We appreciate the opportunity to comment on the IAASB’s proposed International Auditing Practice Statements, IAPS 1000, ‘Special Considerations in Auditing Complex Financial Instruments’, together with the IAASB’s proposals relating to the future application of IAPSs, including:
Following extensive consultation with members of the PwC network of firms, this response summarises the views of member firms who commented on this Exposure Draft. “PwC” refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.
This letter has been drafted in two sections. Section 1 addresses proposed IAPS 1000, ‘Special Considerations in Auditing Complex Financial Instruments’. Section 2 addresses the proposals relating to the status and authority and other proposed amendments relating to the future application of IAPSs. Each section, in turn, details our overall comments together with our responses to the request for specific comments raised in the exposure draft. Our detailed comments in respect of specific paragraphs within the proposed exposure draft are included in the appendix to this letter.
Section 1 – Proposed IAPS 1000, ‘Special Considerations in Auditing Complex Financial Instruments’
We support the proposed IAPS and its practical guidance given the prevalence of fair value accounting and the global economic environment, which continues to present challenges in the valuation of complex financial instruments and disclosures about risks and uncertainties. We support the detailed audit considerations guidance in the proposed IAPS and believe that it will provide a useful source of guidance for those auditors with less experience in auditing complex financial instruments.
There are some areas in the draft which we believe interpret requirements and guidance in the ISAs in a manner that we are not convinced is appropriate, and could result in unnecessary work effort in some circumstances or may be impracticable.
For example, we are concerned by the statement in paragraph 77 that broker or pricing services would likely be considered management’s experts. We believe that this paragraph could be interpreted as stating that when an entity uses any market standard source, the ISA 500 requirements for management experts would apply. In our view such services are often ‘data’, and one source of input that management uses in determining their own estimates. In such circumstances, management is not using the provider of that data as an “expert”, but as one source of support for their own judgments and estimates. We believe that the interpretation in the draft IAPS could create additional work effort that we do not consider to be necessary in some circumstances. Our additional comments on this matter are detailed in the appendix.
Paragraphs 86 & 90 also include a statement that the auditor independently tests inputs and assumptions used by the broker or pricing service. We believe that this is not practicable and, in the majority of cases, cannot be achieved. However, we have provided comments in the appendix on alternative approaches to assessing the reasonableness and reliability of inputs and assumptions to broker or pricing services models that we believe are practical.
Our detailed comments in response to the specific questions raised in the exposure draft are set out below and explain further our views on how some aspects of the proposed content could be improved. We have also provided some specific suggestions for the Board to consider in the appendix to this letter. We encourage the IAASB to address these comments in finalising proposed IAPS 1000.
Request for specific comments
1. Is the material included in the proposed IAPS appropriate in light of the proposed status and authority of new IAPSs?
We believe the content is appropriate. The content provides direction on key areas of focus and examples of common areas of risk or issues that often arise, but does not impose any additional requirements.
2. Is the balance of material included in the proposed IAPS appropriate in light of its purpose of assisting a wide range of auditors on an international basis?
We believe the balance is appropriate. Smaller and medium sized entities may make use of complex financial instruments, so we support the proposed scope of the exposure draft and believe that it would be inappropriate to exclude small and medium sized entities. The proposed IAPS contains guidance explaining the impact that entity size may have on the auditor’s considerations and is the most sensible approach to make a single IAPS applicable to all relevant entities. We have commented further on the practical application of the IAPS to the audit of smaller entities at the end of this section, in response to the specific request for comment.
We also support the exclusion of guidance on difficult areas such as hedge accounting and recognition/de-recognition issues. We believe these issues do need to be addressed in the near future but recognise that these can be complex. We would, therefore, support a conclusion that they would be best addressed in separate IAPSs. Dealing with all such topics in this IAPS would result in a practice statement of significantly greater length and complexity.
3. Does the proposed form of the IAPS, including the use of two separate sections and shaded tables, enhance its readability?
The separation of guidance into two sections is, in our view, useful and section I provides helpful material for auditors with less experience in auditing complex financial instruments. It also helps set the context for the second section and, as a result, aids the readability and understanding of that guidance.
We found the use of ‘tables’, however, cumbersome and ineffective. We understand the IAASB’s objectives for these ‘tables’ (separation of further ‘background’ material), but they detract from the readability of the guidance. In particular, the tables within section I, that are background material and that extend beyond one full page, significantly break the flow of the content. In our view, they would be better located within appendices, most notably tables 2 and 3.
We also disagree with the classification of them as ‘tables’. They do not conform to most readers’ understanding of a table (multiple rows and or columns). Therefore, we suggest that the IAASB consider. if they are retained in the body of the guidance, whether these should be described as an ‘exhibit’ or ‘box’.
4. Should an effective date be established for the proposed IAPS and, if so, what would an appropriate date be?
We have some reservations that an effective date may create a perception that the IAPS carries a greater level of authority than that proposed and may suggest that its content is equivalent to that of application material in the ISAs. However, we acknowledge that it would be beneficial to make clear when such guidance is applicable. We also agree with the IAASB’s assessment that time is required for territories and firms to consider and integrate the guidance contained in the IAPS; in particular into firms’ audit methodologies. We therefore support the inclusion of an effective date to allow for such matters to be addressed. However, we also believe that most firms will have had time to consider guidance during the exposure period and that any changes made to the IAPS upon final release are unlikely to be extensive. A reasonably short period before becoming effective may therefore be appropriate. We suggest that if the final IAPS is approved for release before 31 December 2011, then an effective date of 30 June 2012 would be appropriate.
Application to smaller entities
In our view, it is not sufficiently clear how the guidance in the IAPS may be applied in the context of a smaller entity audit engagement. We believe that the most appropriate solution, to minimise change to the extant content, would be to include an appendix that acts as a navigation aid to the paragraphs in the body of the IAPS that are of greatest relevance to smaller clients; for example Table 4 may be of particular relevance.
We have no comments regarding public interest concerns, adoption by developing nations or regarding translation.
Section 2 – Proposals relating to International Auditing Practice Statements
Withdrawal of existing IAPSs
We have no specific concerns over the IAASB’s proposals for withdrawal of the existing IAPSs, in particular given that these are now out of date. We note that IAPS 1004 and IAPS 1006 are identified as requiring consideration of how such guidance is maintained and updated and that such a project has been included in the IAASB strategy and work plan exposure draft for 2012-2014. We support the IAASB’s assessment of the need to consider revising this guidance in the current economic and regulatory environment.
We acknowledge the comment in the explanatory memorandum that the IAASB plans to consider the withdrawal of existing IAPSs at its June 2011 meeting and note that any proposed withdrawal date will need to consider decisions regarding effective dates for both IAPS 1000 and any future IAPSs.
Clarification of the status and authority of new IAPSs
We strongly support the IAASB’s proposals that IAPSs should not establish new requirements for the auditor. It is our view that where the IAASB believes that a new requirement, or application material designed to provide an interpretation of how a requirement should be applied in practice, is needed, it should be incorporated into an ISA directly. An IAPS should not be a mechanism to impose new requirements.
See also our comment below on the proposed amendment to the preface to the international quality control, auditing, review, other assurance and related service pronouncements, which we believe may not be sufficiently clear in relation to whether and when an auditor is required to consider an IAPSs.
Proposed amendments to the preface to the international quality control, auditing, review, other assurance and related service pronouncements
We note that the proposed amendments to the preface, in paragraph 23, uses the word ‘should’, in the context of the auditor’s determination of whether an IAPS is relevant. We note that this is the drafting convention used in the Preface, and may also have been intentional due to the premise that IAPSs do not impose additional requirements on the auditor beyond those in the ISAs. However, we note that during the Clarity project, the IAASB changed its use of “should” in ISA Requirements to “shall”, because use of “should” was considered to create confusion and uncertainty about whether and when an auditor needed to perform a requirement. If it is intended that the auditor is expected (as stated in the explanatory memorandum) to make a determination of whether the IAPS is relevant to the circumstances of the audit, then we suggest that this be replaced with “shall”. This argument may also apply to the other uses of “should” in the Preface.
Our detailed comments in respect of specific paragraphs within the exposure draft are included in the appendix to this letter.
We would be happy to discuss our views further with you. If you have any questions regarding this letter, please contact Deian Tecwyn (+44 207 212 3695) or Jamie Shannon (+44 141 355 4225).
We encourage the IAASB to address the following matters in finalising proposed IAPS 1000.
In support of the intended authority of the IAPSs, we suggest that a more explicit statement that the content is intended to be educational in nature would be beneficial. We therefore suggest amending the opening sentence as follows:
‘The purpose of this International Auditing Practice Statement (IAPS) is to provide background information andeducational and practical guidance to the auditor regarding special considerations when auditing complex financial instruments.’
A similar amendment may also be considered for paragraph 23 of the preface to the international quality control, auditing, review, other assurance and related service pronouncements.
|IAPS 1000.3||Refer to our comment on paragraph 108 below.|
|IAPS 1000.8||A number of terms included in the IAPS may benefit from being included in a definitions section towards the beginning of the IAPS; for example, in this paragraph, the terms ‘embedded derivatives’ and ‘leveraged finance commitments’. See also Table 1 comment below.|
We believe the wording may be interpreted in a prescriptive manner and would recommend the following amendment:
“Entities with a large volume of trading and use of complex financial instruments may have a more sophisticated control environment and the auditor may be more likely to test controls in obtaining evidence about the completeness, accuracy, and existence of the transactions, having considered whether
Paragraph 37 contains the implication that the existence of a treasury function is an indicator of a high level of understanding of complex financial instruments. Whilst in certain cases this may be true, experience has shown that, even where such functions exist, the understanding of complex financial instruments may not be strong. We therefore suggest removing the last three words of the introductory sentence:
“….SMEs and most non financial institutions:
|IAPS 1000.46||In our experience, existing practice focuses our procedures on testing existence and accuracy of complex financial instruments with consequential evidence relating to the completeness assertion obtained as a result. We therefore suggest that the IAASB may wish to assess whether the implication that evidence over existence is generally obtained from procedures designed to test completeness is a fair reflection of current auditing practices. It may be more appropriate to re-word the paragraph to simply state that completeness and existence are often addressed by the same test(s), without prioritising one assertion over the other.|
We disagree with the last sentence of the second bullet point in this paragraph, which states that external confirmations do not provide adequate audit evidence with respect to the valuation assertion. Where an entity holds instruments that are listed on a recognised exchange, we believe that confirmation of the prices from the relevant exchange is the primary source of audit evidence, as the exchange is the arbiter of the price. We suggest that the last sentence be amended to state that:
|IAPS 1000.63||This paragraph implies that prices for interest rate swaps that are based on the London Interbank Offered Rate (LIBOR) would be Level 1 inputs. We believe that under IFRS 7 such data would be considered Level 2 inputs, on the basis that they are not exchange traded prices but rather LIBOR is a rate used as an input into a pricing model.|
We believe Asset Backed Securities (ABS) may not be the best example of a valuation based on observable data. We suggest a swap, such as an interest rate swap, may be a better example.
We believe there is also scope for confusion by the following sentence:
“This moves the valuation into levels 2 and 3, the assessment of which becomes more judgmental for both the entity and the auditor.”
This sentence indicates that, in all situations, the valuation moves from level 1 to level 2 or level 3. We suggest the IAASB consider re-phrasing this to state that the auditor may need to evaluate whether the fair value measurement moves from level 1 to level 2 or level 3, as the hierarchy is based upon the lowest level input that is significant to the fair value measurement in its entirety.
Based on the above point, we also recommend that, as part of any amendment to the wording, the movement in levels be described as “from level 1 to level 2 or level 3” rather than “into levels 2 and 3”.
|IAPS 1000.68||We believe the final bullet should refer to “market conditions” rather than “marked conditions” at the measurement date.|
|IAPS 1000.74||We believe it would be appropriate to include a reference to ISA 500 at the end of the first sentence to this paragraph.|
As explained in our overall comments to section 1, this paragraph states that broker or pricing services would likely be considered as management’s experts. Despite the qualifying language in the paragraph, that when such services are provided on a contractual basis to provide routine pricing data for use in an entity’s models they may not necessarily be considered to be a management’s expert, we are concerned that this is not sufficiently clear. We believe that this paragraph could be interpreted as stating that when an entity uses a market standard source, such as TOTEM consensus pricing service, or receives a broker quote, then the ISA 500 requirements would apply. Furthermore, there are situations where we believe it is clear that a market data quote using a market standard model (e.g., pricing of a simple cross currency swap using broker quotes on FX and interest rates, or securities with multiple broker quotations with prices in an acceptable range. would not be considered to be experts. In our experience, entities in the banking sector obtain multiple broker quotes, wherever possible, and either use these to validate their own models or to extrapolate a value from the data supplied. In our view, such services are, therefore, often used as one source of ‘data’, and the provider of that data is not an expert.
However, we do recognise that for other services it may be less clear: for example, where pricing services use complex pricing models in addition to market data to calculate prices of derivatives and some structured products. In a situation where an entity has commissioned a third party to provide a unique valuation of an instrument, such as a property valuation, then we would agree that this would fall within the scope of ISA 500.
Further to the above, many pricing services might not actually be experts in this field and there is currently no ‘designation’ for financial instrument valuation providers to identify those that are considered to be experts.
We would also draw parallels with the guidance issued by the IASB Expert Advisory Panel in its publication “ Measuring and disclosing the fair value of financial instruments in markets that are no longer active”. This guidance, in paragraphs 60-61 and 65-66, supports the view that broker quotes and pricing services would not generally be considered management’s experts and that the entity can perform an assessment of whether the price is a representationally faithful measure of fair value.
We therefore believe that it would be helpful to clarify, with a cross-reference to the content in paragraphs 66-67, that in the circumstances when broker quotes and consensus pricing services are being used solely to obtain data for input into an entity’s own pricing models, then the provider of such services would not be considered to be a management’s expert.
There is also an omitted word in this paragraph as shown below:
“Entities that use pricing services on a contractual basis to provide routine pricing datafor use in an entity’s models may not necessarily be considered to be a management’s expert.”
The last sentence of this paragraph states:
“While subsequent events may provide some evidence about the valuation of complex financial instruments, other factors may need to be taken into account to address any changes in market conditions subsequent to the balance sheet date.”
In our view, if an instrument has been properly valued as at the entity’s year end date then changes in market conditions after the balance sheet date are irrelevant and do not impact the valuation at the balance sheet date. We recommend that the sentence be revisited to clarify its intended meaning.
|IAPS 1000.86 & 90|
In both of these paragraphs, there is a reference to testing of inputs and assumptions in scenarios where either management or the auditor has used an expert. As explained in our overall comments to section 1, we believe that independent auditor testing of inputs and assumptions to broker or pricing services is not always practicable or achievable.
Related to our comments on paragraph 77, we note that paragraphs 52, 61-63 and 65-67 of the IASB Expert Advisory Panel guidance states that the entity is required to understand how the valuation has been arrived at and whether it meets the objective of a fair value measurement. Although obtaining information and responses from brokers may prove difficult in some cases, for example, where brokers publish their prices in certain markets free of charge, we nevertheless believe this represents a sensible starting point. Furthermore, as noted in paragraph 65 of the guidance, pricing services may be more willing to share information about its models when they are engaged on a fee paying basis by clients.
Based on the evidence obtained, the auditor can then make an informed assessment about the necessity of performing additional procedures to validate specific inputs and assumptions used by such broker or pricing services. Alternatively, the auditor may consider performing their own valuation using their own inputs and assumptions and determining whether any discrepancies between the two valuations are within tolerable ranges.
We suggest the following change to the wording of footnote 30:
“ISA 540, paragraph 13(d) describes requirements when the auditor develops a point estimate or range to evaluate the entity’s point estimate. Models developed by third parties and used by the auditor may, in some circumstances, be considered the work of an auditor’s expert and subject to the requirements in ISA 620.”
|IAPS 1000.97||In the third bullet, we suggest that use of the term ‘at trade inception’ may be more readily understood than ‘day 1’.|
|IAPS 1000.101||This paragraph does not make clear what actions the auditor may take when management does not understand the assumptions and inputs used by the management’s expert. It is unclear to us whether the implication is that the auditor may obtain the necessary evidence through performing the procedures outlined in paragraphs 102 and 103. We suggest that the IAASB clarifies the responsibilities of management and the auditor in these circumstances and consider adding guidance on actions that may be taken by the auditor, such as requesting management to make necessary inquiries of the broker or pricing service to enable them to obtain a sufficient understanding.|
This paragraph states that ‘disclosures are of equal importance to the amounts recorded in the financial statements’. In many cases this will be a true statement, however, we do not believe it holds in all cases. Where valuation uncertainty is low, the disclosures may be of lesser importance. We suggest the following amended wording:
The majority of the IAPS is focused on balance sheet assertions, with this paragraph, discussing day 1 accounting, being one of few implicit references to the income statement. Given the IAPS is intended to be GAAP neutral, we believe it is appropriate not to include detailed guidance on profit recognition. We suggest instead that some introductory wording towards the beginning of the IAPS may prove beneficial, for example by appending the following suggested wording to paragraph 3:
‘In addition, while the focus of this IAPS is on audit assertions relating to balance sheet recognition and measurement rather than income statement recognition (such as day 1 profit), many of the considerations discussed in the IAPS will also be relevant when considering income statement recognition.’
|IAPS 1000.112||We do not fully understand the intended meaning of the statement in bullet 9 of this paragraph that states:“If applicable, the appropriateness of the basis used by management to overcome the presumption relating to the use of fair values.”The IAASB is asked to clarify this point.|
|Table 1 (d) (ii)||The use of the term ‘hedge transactions’ may not be considered GAAP neutral. If retained, this may also benefit from being included in a list of definitions (refer to comment on paragraph 8 above).|
|Table 2||We believe it would be helpful to include a short statement within the introduction to this table cross-referencing this to table 4, explaining that table 4 has more detailed examples of controls.|
|Table 2||Table 2 presents background information on ‘Types of internal controls that may exist at an entity’. In our view, some of the content is written from the perspective of risk rather than an entity’s controls: for example, ‘commitment to competence’ and ‘organizational structure’. Whilst reference to risk is appropriate, the overall clarity of these paragraphs could be improved by making more explicit the connection with the entity’s controls.|
|Table 2, final paragraph||We do not believe that the last sentence of this paragraph is worded strongly enough. With reference to management putting in place ‘additional procedures’ we believe this needs to go further than ‘often may put’. In our view, some fundamental procedures are always necessary, for example in banking audits.|
|Table 7||We believe it would be helpful to include, within the narrative in Table 7, a reminder that, in addition to the guidance given in the table, the auditor needs to be aware of, and consider, the relevant guidance in the applicable financial reporting framework.|