Hedging

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Hedging Activities Audit Case Example: ABC Manufacturing Company

Context

If ABC Manufacturing Company uses hedging strategies to manage risks such as foreign currency risk, interest rate risk, or commodity price risk, these activities must be accurately accounted for and disclosed. The company’s risk management strategy, including the identification of hedged items and the effectiveness of the hedging instruments, plays a crucial role in the financial reporting of these activities.

Audit Objective

To obtain reasonable assurance that hedging activities undertaken by ABC Manufacturing Company are properly identified, documented, recognized, measured, and disclosed in accordance with the applicable financial reporting frameworks, such as IFRS 9, Financial Instruments, or ASC 815, Derivatives and Hedging, under US GAAP.

Types of Audit Evidence and Documentation for Hedging Activities Assertions

1. Existence

• Case: Verify the existence of hedging instruments and hedged items through inspection of contracts, confirmation with counterparties, or other relevant documentation.

• Documentation: Document the inspection or confirmation processes used to verify the existence of derivatives and underlying hedged items, detailing any discrepancies and resolutions.

2. Rights and Obligations

• Case: Confirm the company’s rights and obligations under the hedging arrangements, including the ability to enforce the contracts and any collateral requirements.

• Documentation: Summarize the examination of contracts and agreements underlying the hedging activities to verify the company’s rights to hedge and obligations, including terms and conditions.

3. Completeness

• Case: Ensure all hedging activities and related derivatives are completely recorded in the financial statements.

• Documentation: Outline procedures for ensuring the completeness of hedging activities, such as reconciliation of hedging transactions recorded in the accounting system with contracts and confirmation responses.

4. Valuation and Allocation

• Case: Assess the fair value measurement of hedging instruments and the effectiveness of hedging relationships.

• Documentation: Document the valuation techniques and effectiveness testing methodologies used for hedging instruments, including key assumptions and models, and the results of effectiveness assessments.

5. Presentation and Disclosure

• Case: Review the financial statements to ensure hedging activities are correctly classified, described, and disclosed in accordance with reporting standards.

• Documentation: Note the evaluation of disclosures related to hedging activities, ensuring they include information on the company’s risk management strategy, types of hedges, fair values of hedging instruments, and the effects on financial position and performance.

Additional Considerations

• Risk Management Policies and Objectives: Document inquiries made to management about the company’s risk management policies and objectives for hedging activities, including how these activities fit into the overall risk management strategy.

• Internal Controls: Evaluate the design and implementation of internal controls over hedging activities, including the process for identifying hedged items, entering into hedging instruments, and effectiveness testing.

• Impact on Financial Statements: Assess the impact of hedging activities on the financial statements, especially the statement of comprehensive income, and document any material effects or hedge ineffectiveness recognized.

• Communication with Those Charged with Governance: Discuss significant findings or issues identified during the audit of hedging activities with management and those charged with governance, focusing on the adequacy of disclosures and the company’s compliance with hedging accounting standards.

Conclusion

The audit of hedging activities is vital to ensure that these transactions are appropriately accounted for and disclosed in the financial statements, reflecting the company’s risk management strategies accurately. Documenting the audit procedures and findings related to hedging activities provides a foundation for the auditor’s opinion on the financial statements, enhancing the reliability and transparency of the reported financial information.