- Failure to implement and enforce internal controls could lead to either lofty trading profits or excessive losses. Such results are often a sign of traders taking unreasonable risks, and a firm's tolerance for risk is normally governed through internal controls. All auditors consider a client's internal controls in deciding the extent of substantive tests that will be required as part of the audit. However, auditors examine internal control in much greater depth when auditing public companies, since this is required by the Sarbanes-Oxley Act and Securities and Exchange Commission rules. One of specific areas of internal control that an auditor will evaluate is the firm's "house limits" on open-trade positions and methods for enforcing those limits with traders. He also will examine policies and compliance concerning the types of securities and commodities that can be traded as a way of mitigating risk.
- The audit plan should consider the possibility of fraud when trading results are unusually good or bad. High profits may be a sign of management's manipulation of financial reporting rather than real profits. Unexpected trading losses may result from traders' or financial employees' misappropriation of funds. Accounting standards require an auditor to question the audit committee of the board of directors about whether they know of or suspect fraud within the company. Standards do not require auditors to plan audits to uncover misappropriation of assets, but they are expected to consider the possibility of financial statement fraud in audit plans and procedures. Interviewing multiple employees and conducting more complete substantive tests of details of balances are both procedures that auditors use to uncover financial statement fraud.
- Outsized gains or losses may also lead auditors to inquire about possible violations of law other than fraud. Auditors are not required to search for violations, but any material violations discovered must be communicated to directors. Unexpectedly large gains may cause an auditor to consider possible violations involving insider trading or manipulating markets. Major losses at a broker-dealer may lead an auditor to investigate whether the firm's finances have deteriorated enough to run afoul of laws setting net capital and customer reserve requirements. If the requirements are not met, the firm could face liquidation by the Securities Investor Protection Corporation, so the auditor might issue an opinion questioning the client's ability to continue as a going concern.
- When profits represent unrealized gains on trading securities held by the firm, the audit plan should address methods for valuing those securities. Assigning unrealistically high market values to securities could be a form of financial reporting fraud, but it could also result from carelessness or simple error by financial personnel. The auditor will assess whether the firm has a clear, written policy for valuing securities and whether it is followed by the responsible employees. The auditor will confirm that valuation activities are performed independently of the trading function and that management does not override valuations that are received from objective, external sources.
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