Due to its complexity and wide-range of risks inherent with the use of financial statement, developing an audit approach for financial instruments is crucial. Paradoxically; on one hand financial instruments are used (by entities) to reduce exposures to certain business risk, on the other hand the inherent complexities of some financial instruments also may result in increased risk—business and material misstatement risk—along with the increase of the financial instruments usage.

It has been long-known that financial instruments vary in complexity that come from various source: (a) volume of individual cash flows—where a lack of homogeneity requires analysis of each one or a large number of grouped cash flows to evaluate; (b) complex formulas for determining the cash flows; and (c) uncertainty or variability of future cash flows. In addition, sometimes financial instruments that ordinarily—which otherwise are relatively easy to value—could become complex to value because of particular circumstances.

The accounting for financial instruments under certain financial reporting frameworks or certain market conditions could be complex too. The definition of the financial instruments themselves could be vary in wide-range—from simple loans and deposits to complex derivatives, structured products, and some commodity contracts. Financial instruments could be cash; or the equity of another entity; or the contractual right or obligation to receive or deliver cash or exchange financial assets or liabilities; and so forth. So, how do you develop audit approach for financial instruments? Before going to the main topic, let’s have a look why an entity uses financial instruments and what are the risks inherent with the usage.