On June 2007, the Governmental Accounting Standards Board "GASB" issued the Exposure Draft "Accounting and Financial Reporting for Derivative Instruments". The objective of this draft is to provide a framework for measurement, recognition, and disclosure of derivative instrument transactions.

When this proposed standard becomes effective, the state and local governments will increasingly use derivative instruments for hedging activities, whether cash flow hedging or fair value hedging, knowing that there is an accounting standard to follow. On the other hand, for auditing the derivatives, the government auditors do not have enough detailed guidelines in the 2007 Government Auditing Standards "the Yellow Book" to plan and perform derivatives audit.

The objective of this article is to present a comprehensive framework for auditing derivatives to be used by government auditors. This framework is based on the Statement on Auditing Standard "SAS" No. 92 "Auditing Derivative Instruments, Hedging Activities, and Investments in Securities".

Definition of Derivative Instruments

1. It has (1) one or more underlyings and (2) one or more notional amounts (3) or      payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required. 
2. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
3. Its terms require or permit net settlement; it can readily be settled net by means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Types of Derivatives

Future Contract: a standardized contract agreement calling for the delivery of a specified quantity of a commodity at a specified date in the future. The future contracts are usually traded in an organized market such as Chicago Board of Trade.

Forward Contract: a customized contract calling for the delivery of a specified quantity of a commodity at a specified date in the future. The forward contracts are traded over the counter.

While futures and forward contracts are both a contract to deliver a commodity on a future date at a predetermined price, they are different in several respects:
Forwards only transact when purchased and on the settlement date. Futures, on the other hand, are rebalanced, or "marked-to-market", every day to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset.
The lack of rebalancing of forwards means that, in some cases, due to movements in the underlying's price, a large differential will build up between the forward's delivery price and the settlement price. 

This means that one party will incur a big loss at the time of delivery (assuming they must transact at the underlying's spot price to facilitate receipt/delivery). 
This in turn creates a credit risk. More generally, the risk of a forward contract is that the supplier will be unable to deliver the required commodity, or that the buyer will be unable to pay for it on the delivery day. 

The rebalancing of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. This means that there will usually be very little additional money due on the final day to settle the future.

Swap Contract: a contract to exchange a fixed stream of income with a variable stream of income. For example, interest rate swap contract. A government can use interest rate swaps to limit, or manage, its exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.

Option Contract: there are two types of option contracts:
Call Option: an Option contract that gives the holder the right to buy underlying asset or security at a specified price for a certain fixed period of time. 
Put Option: an option contract that gives the holder the right to sell underlying asset or security at a specified price for a certain fixed period of time. 
There are two styles of options:
American Option Style: a style of option that can be exercised anytime during the contract period, and European Option Style: A style of option that can be exercised only at its maturity/expiration

Swaption Contract "An option on a swap": an option granting its owner the right but not the obligation to enter into an underlying swap. While options can be traded on a variety of swaps, the term "swaption" typically refers to interest rate swaps.
There are two types of swaption contracts:

Payer Swaption which gives the owner of the swaption the right to enter into a swap where they pay the fixed interest and receive the floating one, and

Receiver Swaption which gives the owner of the swaption the right to enter into a swap where they will receive the fixed interest and pay the floating one.

Future Option Contract "An option on a future contract": it is a right not an obligation to buy or sell a future contract, when this option is exercised, the holder receives a future contract to buy or sell certain commodity at a certain price in the future.

Recognition and Measurement of Derivative Instrument

The proposed accounting standard stated that the derivative instruments should be measured at the fair value and reported on the statement of net assets "balance sheet".

Changes in fair value of derivative instruments should be recognized as investment income in the statement of revenues, expenditures, and changes in fund balances, unless the derivative instrument is a hedging derivative instrument. The changes in fair value of hedging derivative instruments are reported as either deferred inflows or deferred outflows in the statement of net assets regardless of the measurement focus or basis of accounting of the reporting unit. For example, the changes in fair values of an interest rate swap that substantially offset the changes of a government's variable-rate debt payments should be reported as deferrals in the statement of net assets.

In case of termination of the derivative contract, the balance in the deferral account should be recognized on the change statement as an element of investment income.

Derivatives Audit Program

SAS # 92 requires the auditors to design audit program to obtain reasonable assurance of detecting misstatements of assertions about derivatives. When designing such program, the auditor should consider the inherent risk and control risk for these assertions.

Inherent Risk Assessment

The government auditors should consider the following in assessing the inherent risk related to derivative instrument:

• The agency's objective for using derivative, speculation or hedging.
• The complexity of the features of the derivative instrument
• Whether the derivative transaction involved the exchange of cash
• The government agency's experience with derivative
• Whether a derivative is freestanding or an embedded feature of a contract.
• Whether the agency accountants fully understand the accounting standard for derivatives.

Control Risk Assessment

The government auditors should obtain understanding of internal control over derivative transactions. This understanding includes:

• -How the agency's derivatives transaction are initiated
• -The accounting records and supporting documents
• -The process the agency uses to report information about derivatives transaction After obtaining the understanding of internal control over derivatives transactions, the auditor should assess control risk. The auditor can assess the derivatives control risk at the maximum level and rely entirely on substantive tests, or he/she can perform tests of control and assess the control risk below the maximum level.

Substantive Tests

The government auditors should use the assessed level of inherent risk and control risk for derivative transactions to determine the nature, time, and extent of the substantive procedures to be performed to detect material misstatements of the financial statement assertions.

• Testing for Existence:
  • Send confirmation to the issuer of the derivative instrument.
  • Send confirmation to the broker/dealer to confirm the settled transactions and the unsettled transactions.
  • Physical inspection of the derivative contract.
  • Inspect supporting documents.
  • Perform analytical procedures including ratio analysis and trend analysis.
• Testing for Completeness
  • Request the counterparty to a derivative to provide information about it.
  • Inspect financial instruments and other agreements to identify embedded derivatives.
  • Reading the minutes of meetings of the agency top management.
  • Inspect documentation for activity subsequent to the end of the reporting period.
• Testing for Rights and Obligations
  • Confirm significant terms with the counterparty to a derivative, including the absence of any side agreements.
  • Inspect underlying agreement and other forms of supporting documentation.
• Testing for Valuation
  • If the derivatives are listed in on national exchanges or over-the-counter markets, the auditor should obtain evidence to support the fair value from sources such as financial publications, the exchanges, and NASDAQ.
  • If the quoted market prices are not available for a derivative, most of the time the government agency is using a valuation model for pricing the derivative such as, Black-Scholes Option Pricing Model. In this case the auditor should: 1- Assess the reasonableness and appropriateness of the model. 2- Calculate the derivative fair value using the designated model. 3- Compare the auditor's calculated fair value with the recorded one. 4- Compare the fair value with subsequent or recent transactions.
• Testing for Presentation and Disclosure
  • Obtain evidence that the accounting method selected and applied have general acceptance.
  • Evaluate the appropriateness of the accounting method in the circumstances.
  • Evaluate the informational content of the financial statements and the related notes.
  • Obtain evidence that the agency disclosed in the footnotes the purposes of using the derivative instruments (cash flow hedging, fair value hedging, or speculation).

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