Critical Issues for Auditors of Finance Companies

8/12/2019 Critical Issues for Auditors of Finance Companies

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7/24/20

Critical Issues for Auditors of Finance

Companies

Manil Jayesinghe

Partner, Ernst & Young


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7/24/20

CRITICAL ISSUES ARISING

FROM LKAS/SLFRS

What happened to the Balance Sheet?

Assets

PPE

LandLeases

FullyDepreciatedAssets

ComponentAccounting

UsefulLives

DeemedCostontransition

Investments(FinancialAssets)

Leases

OperatingVs

Finance

(review

of

contracts

and

arrangements)

Straightliningofrental

LeaseReceivables(Provisioning)

DeferredTaxAsset

Equity & Liabilities

DebtVsEquity

FinancialLiability(Derivatives)

DeferredTaxLiability


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What happened to the Income Statement?

Revenue

Revenue recognition point for land sales

Lease revenue Straightline method

FV gains and losses from investment in shares

Depreciation

Deferred Tax

OCIFV changes from AFS securities

Revaluation of land and buildings

Exchange differences on translation of foreign operationsAdjustments arising from hedges

Defined benefit plans

How will your Income Statement Look?

6


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Practical Scenarios

Auditing the transition entries and the exceptions used

under SLFRS 1

Focus on the areas of judgments, estimates and the

accounting policy changes

Specific reference to related parties and the transactions

done with them is it at arms length including terms

In the case of estimates, focus on the assumptions,

methodology, the independence and the qualification of

the managements experts.

Key

Areas


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PPE

Fully Depreciated Assets

Scope of PPE (PPE vs

Inventory, IP)

Determination of Components

Determination of Useful lives

Applicability of residual values

Use of Deemed cost option on

transition

Land Leases Operating vs

Finance

Future

- Revisit useful lives

- Identification of

components

- Residual values

- Determination of

operating lease vs

finance lease

Investments and other placements

OtherI nves tm en ts O pt io ns Reasonforclassification

FutureStatus

T.BondInvestment

L&R No activemarket

Fixedmaturity Entityshouldestablishaprocesstoclassifytheinvestments

fromtheinception(Pointofenteringintodeal).

Properprocessshouldbeinplaceto verifytheabilitytohold

thesecuritywhenclassifyingtheportfolioclassifiedas HTM.

Processtobeinplacetorestrictreclassificationandpre

maturedisposalofHTMportfolio.

Processtodeterminethefairvaluechangesbetweenthe

tradedate

and

settlement

date

if

entity

opts

to

adopt

settlement

dateaccounting.

Processshouldbeinplacetoverifytheratesusedtofair

valuethefinancialinstrumentstoreflectactualmarket

conditions.

HTM

Fixed Maturity

Intentionandthe

abilitytoholdtillthe

maturity

T.BillsTrading FVTPL Intentiontotradein

shorttomediumterm

T.BondTrading FVTPL Intentiontotradein

shorttomediumterm

Reclassification and Re-measurement of Balance Sheet as at 31.Dec. 2010

Investment in

Shares

Classification of balances at initial measurement (FVTPL or AFS)

FV of balances

Identification of Impairment (Significant and prolonged) AFS portfolio

Disclosures


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Provision for bad & doubtful debts

Specificprovisionforindividuallysignificantbalances

Identifyimpairmentindicators

Forimpairedbalances

Obtainexpectedcashflows

Discountthebalances

CollectiveImpairment

Identifyandsegregatedebtorbalancesbasedonriskcharachterists

Computehistoricallossratio

Evaluatebasedonjudgment,whetherhistoricallossratiosrequirechange

Continuous improvement to judgments! Ex: Gold prices, property prices, etc.

Improvements on identification and segregation of risk characteristics based

on changes in the business

Judgmental adjustments to historicalloss experience : Proposed Model

Step 01: Identify Macro economic factors and portfolio factors that has impact on each and every segment

Step 02: Determine the weight of each factor to the relevant segment of the portfolio.

Step 03: Establish guidlines for ranking the current condition with the historical average conditions.

Step 04: Rank each and every economic and portfolio factors on a1 to 5 scale and work out weighted average rank foreach and every portfolio.

Step 05: Adjust the historical average PD/NFR based on the weighted average rank

Rank Comparable Economic/portfoliocondition AdjustmentPD1 Significantly Improved Significantly Increase

2 Improved Increase

3 Same NoChange

4 Adverse Decrease

5 SignificantlyAdverse Significantly Decrease


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Economic Factors & guidance forscoring

46

48

50

52

54

56

58

60

62

64

Jan1 2 Feb12 Mar1 2 Apr12 May12 Jun1 2 J ul1 2 A ug1 2 Sep1 2 Oct1 2 Nov1 2 D ec1 2 Jan1 3 Feb13 Mar1 3 Apr13

Thousands

Goldprice(LKRpersovereign)

Adjusted price

16%drop16%drop

Trend in gold prices ( Local and global)


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The model

Impairment

Dud articles = No of articles X Rs. 10K per

Not Fallen due = Nil

Settled in full before

the auction = Nil

Recovery through

auction = PD X ( % to auction ) X Loss at auction

Fallen Due

Settled in full before

the auction = Nil

Recovery through

auction = ( % to auction ) X Loss at auction

Pawning

portfolioNot Defualt

Defualt

Segments Parameters FormulaIdentifieddudarticles Noofarticles

Rs.10Kperarticle

=NoofarticlesXRs.10Kper

Advances notfallen due

Probability

of

default

(PD)

%settledthroughauction

Lossatauction

=PD

X(%

to

auction

)XLoss

at

auction

Advances fallendue %settledthroughauction

Lossatauction

=(%toauction)XLossatauction

introduction

Process Improvements

Process for on going estimation of LGD

Calculation methods, formulas, assumptions and templates

Appropriate validation levels

Judgmental adjustments based on observable market

conditions

Review and estimate the historical loss experiences

On time receipt and availability of required data files

Appropriate automation of the calculation process

Quantify the characteristics of recovery process

Eg :Time period between letter of demand to foreclosure

Average recovery cost as a percentage of disposal value

Annual value increase percentage for mortgage property

Stability of Loss Given Default (LGD)

In the initial stage of implementation there are many practical

issues of estimating loss given default such as

Difficulties to obtain historical data

Inadequate population of realized loss cases to formmeaningful statistical conclusion

Less than 3years historical data may distort LGDestimates

Lack of expertise to make proper judgmentalestimates

Consideration of Exposure at Default (EAD)

Individual Impairment Collective Impairment

Re-visit objective evidence that has been determinedlast year in the light of current market (legal, political,

economic) conditions

Strengthen the process to capture guarantees obtained

on behalf of loans, and the measurement of suchguarantees.

Detailed instructions and guidelines on estimation of

timing and the amount of expected cash flows

Operational procedures on :

Segregation of related responsibilities

Target deadline

Appropriate review and authorization level


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Leases

Leases Operating vs Finance

Bargain purchase option at the end of the lease period

Lease term is for the entirety of the useful life of the

asset

Sale and leaseback

Gain/loss on sale

Revenue recognition

Impairment of Assets

Arms length

priceWhen?

AnnualAssessment

Intangibleassets

Withindefiniteusefullife

Notyetavailableforuse

Goodwillthroughbusinesscombination

Otherassetswhenimpairmentconditionsexist

Higher

Issues

IdentificationofCGU

Identificationof

Impairment

indicators

Measurement

Disclosures

Armslengthprice

Costsofdisposal

FVlesscoststo

sell

ValueinuseExpectedfuture

cashflowsdiscountedtopresentvalue

Impairment

CarryingAmount

Recoverableamount


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Disclosures!

Disclosures!Disclosures!

Disclosures LKAS24 RelatedParties

Parties

Identificationrelatedparties

Subsidiaries,jointventuresandassociates

Significantowners

KMPsandclosefamily

members

Entitiesneedto

Instituteprocessesto

providethesedisclosures

Reviewsystemcapabilitiesto

trackinformation

Identification of related

parties and the entity Subsidiaries , joint

ventures and

associates

Significant owners

KMPs and close family

members

Transactions entered into

with RP

Companies needs to ins titute

processes to provide thesedisclosures

Disclosures

KMPcompensationin

totalandforeachcategory

Parent(s)Significant

investors

Subsidiaries

JV/Associates

KMP

OtherRP

Relatedpartieshavetheabilitytoinfluencetransactions!!!


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Disclosures SLFRS 8 - Operating Segments

DeterminationofaChief Operating Decision

Maker(CODM)

Identifyreportablesegments

Componentwhichmayearnrevenueand

incurexpenses

Resultsareregularlyreviewed byCODM

financialinformationisavailable

Aggregationisallowedifsimilar in

natureofproductsandservices

natureofproductionprocess

classofcustomer

distribution

methods

and

regulatoryenvironment

Disclosures SLFRS 7 Financial Instruments

All risks arising from fi nanc ial instr umen ts to be di sc losed.

Are youreadytodisclose?Riskmanagementpolicies Managementsobjectives,policiesand

processesformanagingrisks

Your creditrisk,liquidityriskandmarketrisk

Baddebts(CreditRisk)

Disclosureofmaximumexposureto Baddebt/creditrisk

Creditquality financialassetswithcreditriskthatare

neitherpastduenorimpaired

LiquidityRisk

Maturityanalysis

financial

liabilities

showing

remaining

maturities

MarketRisk

Foreignexchangerisk,interestraterisk,etc.

Sensitivity Disclosures

LevelofFairValue(FVHierarchy)

Thesewillbesubjecttoaudit!

Properprocess/systemstogatherdata

Disclosureswillbecomparedbyanalysts/stakeholders


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FUTURE STATE

What reliefs will be out the window

Exemption for Share based options vested before

transition

Formula method for Actuarial valuation of employee

benefits

Exemption on SLFRS 7 FV, credit risk, market risk

Recasting the comparative quarters for 2013

What is new?New principles for Business combinations


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SLFRSConversionImpact

OrganizationTechnology

Process

Changes

in

Presentation

New

Valuation

Rules

Addi tio nal

Disclosure

Requirements

SLFRS

Conversion

ERP Environment

Financial Systems

Archi tect ure

Regulatoryrequirements


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Corporate Governance Direction 3 of 2008

Report by the board on the companys internal controls over financial

reporting ( designed to provide reasonable assurance regarding the reliability

of Financial reports)

The external auditors certification on the effectiveness of IC mechanism in

respect of any statements published after 31/3/2010

The external auditors certification of the compliance with the act and rules

and directions issued by the monetary board ( after 1.1.2011)

What is Next?


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NEW SLFRSs from 2014.

NewSLAS

SLFRS10

SLFRS11

SLFRS12

SLFRS13

SLFRS9

SLFRS 9 Financial Instruments

Classification &

Measurement

SLFRS 11 Joint

Arrangements

SLFRS 12 Disclosure

of Interests in OtherEntities

SLFRS 13 Fair Value

Measurement

SLFRS10Consolidated

FinancialStatements

MovingTarget


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Moving Target

Makesurethatthecriticalareasofjudgementhasbeenlookedintobyexperiencedstaff

BeawarethattheknowledgeoftheclientsstaffmaybeinadequatetopreparefinancialstatementsbasedonLKAS/SLFRS

Thenewstandardsrequirealotofinputbyoperations.Theseinputsmaynotbeadequatelycontrolled

Differentoptionsavailableintheapplicationofthestandards

Theprinciplebasedstandardsrequiretheexercisingjudgements.Thisrequirestobeauditedtoensurethatthetransactionisreflectedproperly

Theauditorsshouldgettheauditcommtounderstandthekeyjudgementsandassumptionsandtakeresponsibilityforthese

Auditorshouldbeawareofcreativereporting.FSshouldreflectwhatispractisedbythe

company(SLFRS

7risk

management

)

ExtrafocusrequiredwhenauditingImpairmentandRPT

Inthecaseofgroupaudits makesuretheparentspoliciesandconsistentlyappliedinthegroup

Thank You

Documents

Critical Issues for Auditors of Finance Companies