Back Office in Banks

A back office in a bank simply refers to the section where all the work is done in connection to finance. The back office is responsible for the accounting and financial processing of both customers and staff.

A bank has many different jobs ranging from service, administration, and operations to more specialist functions like fraud prevention or investments. The work of the back office can be divided into three main parts: Financial administration, accounting, and payment transactions.

In this article, we are going to look at what is a back-office and what does it do.

What is a back office in banks

A back-office in banks is an area where essential functions are carried out. The objective of a back office at a bank is to provide the financial infrastructure that enables the rest of the bank to run and prosper.

The main areas covered by the back office include processing customer accounts, financing, managing information technology for both front-office (customers) and back-office (staff), managing money transactions, and providing services such as reporting, risk management, and auditing.

Every bank requires a back office to provide these critical functions, which allow for the smooth running of the front office. A back office in a bank is where all of the paperwork, transactions, and general management tasks are processed in order to keep a bank running.

What does the back office do

The main elements of work done by the back office can be divided into financial administration, accounting, and payment transactions.

Financial administration

In this area, the back office deals with things such as:

• Orders to open accounts and requests for authorization.
• Processing transactions on accounts and preparing customer statements.
• Managing information technology in support of other areas of the bank (e.g., by providing data entry services).
• Management of information systems (e.g., databases of account information).
• Management of money and other assets.

Accounting

In this area, the back office deals with things such as:

• Preparing financial reports for management and external parties.
• Preparing a variety of specific documents that are required by law or regulations.
• Providing a payment service (e.g., by making transfers) and processing payments (e.g., cheques, cards, direct debits).

Payment transactions

The back office is responsible for carrying out at least some of the following tasks:

• Preparing information about payment transactions for processing (e.g., credits and debits).
• Transmitting payment instructions.
• Arranging for the provision of cash (e.g., banknotes and coins) or other forms of settlement.
• Processing payments by direct debit, credit card, invoice, etc.

Why back offices are important

A back office in a bank is an essential element for most banks. Banks can not function without some form of back-office organization, as they are responsible for the processing and administration of many activities crucial to a smooth financial system.

The primary objective of banks is to provide customers with services such as checking accounts and savings accounts, home loans, wealth management services, and others. Because of the vast amount of customer activities that take place in a bank, a back office is vital in allowing the working parts of the bank to interact properly and smoothly.

Without a back office, banks would not be able to function as customers would have no way to get access to their accounts or finance. The back office ensures that a bank is able to carry out its critical processes in the face of high demand for banking services.

Conclusion

A back office is the backbone of a bank. It is a place where all of the management and documentation processes take place in order for a bank to function. In this way, back offices are important because they allow front-office staff to focus on their primary objective: serving customers.

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Econometrics for Finance

What is Econometrics?

Econometrics is a field in economics that helps economists quantify economic theories. Historically, most economists only relied on economic theories and hypotheses. However, some of these theories were unproven due to the lack of quantified information available. With econometrics, economists were finally able to test those theories and develop new ones.

Econometrics uses mathematical and statistical models to describe economic theories. It aims to convert qualitative statements into quantitative information that can help in economic policymaking. Due to its benefits, econometrics has become a crucial part of the economic policy- and decision-making process. However, econometrics isn't only beneficial for economic analyses. It can also have some uses in the world of finance.

What is Econometrics for Finance?

Econometrics for finance is the application of econometrics for financial purposes. In other words, it is the use of econometrics to analyze financial data. Econometrics for finance is a branch of financial econometrics. It usually concerns capital markets, corporate finance, financial institutions, and corporate governance.

Financial analysts can use econometrics for several financial purposes. Primarily, it can help analyze the price of various financial assets traded in competitive, liquid markets. However, it can also be helpful in risk management and decision-making. Despite its uses, financial econometrics is still a developing field. However, there are some books that explore this field, some of which are as below.

Introductory Econometrics for Finance

Introductory Econometrics for Finance by Chris Brooks is a great book for those who want to learn the basics of the field. The book teaches the most common empirical approaches in finance in detail. It illustrates how financial analysts can use econometrics in finance. On top of that, it also includes detailed case studies to explain how they can use the techniques in relevant financial contexts. Overall, it is a well-written and comprehensive book for beginners.

The Econometrics of Financial Markets

The Econometrics of Financial Markets teaches econometrics for finance through statistical techniques with the context of a particular financial application. However, the book caters more to advanced users rather than beginners. The Econometrics of Financial Markets covers the most prominent topics in empirical finance. It also contains detailed recent examples and problems designed to help readers apply concepts to their work.

Financial Econometrics: Models and Methods

Financial Econometrics: Models and Methods is a book written by Oliver Linton, a world-renowned financial econometrician. This book explains financial econometrics through developments in econometrics and finance over 20 years. It also covers the fundamental principles of the field to get readers started. The book also has exercises and examples to explain concepts in a practical manner.

Financial Econometrics: From Basics to Advanced Modeling Techniques

Financial Econometrics: From Basics to Advanced Modeling Techniques is a book that introduces readers to concepts and theories related to the field. It includes background material on time series, probability theory, and statistics. On top of these concepts, it also includes illustrative examples for the topics discussed. The book comes from multiple authors who have experience in the finance and econometrics fields.

Financial Econometric Modeling

Financial Econometric Modeling is a book that combines financial theory with econometric methods. The book discusses the power of data to introduce users to the global financial universe to which all modern economies relate. It includes foundational ideas, relevant econometric techniques, and areas of modern financial econometrics. It is an introductory book that is relevant to everyone interested in financial econometrics.

Conclusion

Econometrics is a field in economics that involves using mathematical and statistical methods to explain economic theories. Econometrics for finance is the application of econometrics concepts in the field of finance. It has become prevalent in the financial world. Several books can help readers understand financial econometrics, as listed above.

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Using the Gaussian Mixture Models to Identify Market Regimes

Characterizing the market is an important step in trading system development. Currently, there exist a couple of approaches for identifying market regimes such as using trend and/or volatility filters, machine learning techniques, etc. Reference [1] proposed an approach that uses the Gaussian Mixture Models to identify market regimes by dividing it into clusters.

In statistics, a mixture model is a probabilistic model for representing the presence of subpopulations within an overall population, without requiring that an observed data set should identify the sub-population to which an individual observation belongs. Formally a mixture model corresponds to the mixture distribution that represents the probability distribution of observations in the overall population. However, while problems associated with "mixture distributions" relate to deriving the properties of the overall population from those of the sub-populations, "mixture models" are used to make statistical inferences about the properties of the sub-populations given only observations on the pooled population, without sub-population identity information. Read more

Using the Gaussian Mixture Models, the market was divided into 4 clusters or regimes,

1. Cluster 0: a disbelief momentum before the breakout zone,
2. Cluster 1: a high unpredictability zone or frenzy zone,
3. Cluster 2: a breakout zone,
4. Cluster 3: the low instability or the sideways zone.

As an application, the authors used the regimes to analyze the performance of triple moving average trading strategies,

This research work has demonstrated that conventional Triple simple moving average and Triple exponential moving average trading strategies cannot produce desirable profits throughout all market regimes. As a result of this inefficiency, we identified the best market regime where each of the strategies can be used to achieve better trading portfolio returns.

In short, the triple moving average trading systems did not perform well. However, the authors managed to pinpoint the market regimes where the trading systems performed better, relatively speaking.

We observed the following,

• Using more complex trading systems doesn’t necessarily yield better results. Simpler moving average trading systems can give better risk-adjusted returns.
• It’s interesting to use the Gaussian Mixture Models to divide the market into regimes and analyze the trading systems’ performance. However, the analysis is after the fact. Without developing an efficient mechanism to detect the regime change and incorporate it into a trading system, characterizing the market after the fact is of little use.

References

[1] F. Walugembe, T. Stoica, Evaluating Triple Moving Average Strategy Profitability Under Different Market Regimes, 2021, DOI:10.13140/RG.2.2.36616.96009

Originally Published Here: Using the Gaussian Mixture Models to Identify Market Regimes

What Does Enterprise Risk Management Mean

When you hear the word “enterprise,” what springs to mind? Maybe a big company like Coca-Cola or IBM. Rarely do people think of an enterprise as being their own business? But in fact, every small business is also an enterprise.

The thing that differentiates a small business from other types of enterprises is its size and scope. When it comes to managing risk, there are many similarities between large companies and smaller businesses: both need to assess the risks they face; both need to identify ways of reducing those risks; and both need to put measures in place so that if disaster strikes they can still carry on trading while repairing any damage done by the event.

So both require an effective enterprise risk management system to run a healthy business. But what exactly is enterprise risk management, and how does it work? Let's find out!

What is enterprise risk management

Enterprise risk management (ERM) is the ongoing process of identifying, measuring, and mitigating risks to your organization in a systematic way. The overarching goal of ERM is to ensure that your business maintains continuity so that you can continue operating when a risk materializes.

It may sound simple in theory, but it's not always easy to do in practice.

But why is this such an important concept? To answer that, we can look at what happens when companies do not take their risks seriously enough.

A 2008 report by the Association of Certified Fraud Examiners found that around 5% of global organizations go bankrupt within a year of suffering a major risk incident. And according to research by the Ponemon Institute, organizations that do not have an ERM strategy in place are five times more likely to go out of business than those that do.

So it's safe to say that any company – large or small – cannot afford to be complacent about its risk management strategies. But what is enterprise risk management and how can you apply it to your business?

How does enterprise risk management work

Enterprise risk management is a long-term process that starts with the creation of an ERM program. This program contains all the essential elements required to establish your company as a serious professional business.

• It defines who's responsible for making decisions about risks
• It sets out how you will monitor and measure risks
• It shows how you will make the business aware of emerging risks
• It demonstrates how problems will be dealt with once they've occurred

Once your program has been set up, enterprise risk management then becomes part of everyone's daily work – your team must all learn about the risks the business faces and play their part in reducing the chance of those risks occurring.

Enterprise risk management benefits

As we've seen, enterprise risk management is all about reducing the chance of your business suffering from a significant event.

Here are some of the benefits of enterprise risk management

• Your business won't go bankrupt
• You'll see a decrease in risk incidents
• You can continue operating when disaster strikes
• Your business will be a safe place to work
• You will avoid costly fines and legal issues

Conclusion

Enterprise risk management is a powerful practice. If you're interested in this approach, there are several ways to get started. It can be done using something as simple as a spreadsheet or whiteboard; alternatively, you may wish to use an ERM software solution to keep track of your risks and progress. The important thing is that it's done!

Originally Published Here: What Does Enterprise Risk Management Mean

What are the Types of Audit Opinions

The primary objective of most audit assignments is for the auditor to express an opinion regarding the subject matter. Usually, they report it in a document known as the audit report. The term audit opinion defines a statement provided by auditors about a given subject matter. This opinion may differ based on the type of audit engagement, its scope, and auditors' findings.

When it comes to external audits, auditors can only express an opinion in two forms. These include unmodified and modified audit opinions. However, the modified audit opinion has three other types. In total, there are four types of audit opinions that auditors may express in an external audit report. These opinions relate to a subject matter, which usually includes financial statements.

What are the types of Audit Opinions?

There are two primary classifications of audit opinions, including modified and unmodified audit opinions. Auditors express this opinion in a written statement in the audit report. An explanation of what each of these audit opinions is and what they mean is as below.

Unmodified Audit Opinion

An unmodified audit opinion is a standard audit opinion provided by auditors. Auditors use this opinion when the given subject matter matches the requirements of the suitable criteria. Similarly, unmodified audit opinions express auditors' satisfaction in two regards. The first relates to auditors obtaining sufficient and appropriate audit evidence related to the subject matter. The second involves the subject matter meeting the suitable criteria.

The unmodified audit opinion, or unqualified audit opinion, usually provides a green signal to stakeholders. However, it does not imply that the given subject matter is free from all misstatements. Some immaterial misstatements may still exist. Unmodified audit opinions do not modify the audit report. However, they can still be a part of modified audit reports.

Modified Audit Opinion

Auditors may also express a modified audit opinion. Usually, this happens if the subject matter can't fulfill the criteria for an unmodified audit opinion. A modified audit opinion also modifies the audit report. Usually, this opinion is a negative sign, implying the financial statements may have material misstatements. There are three types of modified audit opinions that auditors may express, as follows.

Qualified Audit Opinion

A qualified audit opinion is a type of modified opinion in which auditors express that the subject matter has material misstatements. Similarly, it may also relate to unavailable audit evidence. However, these material misstatements or unavailable pieces of evidence are not pervasive. The term pervasive relates to misstatements in the subject matter affecting users' decision-making. Therefore, auditors will only specify the areas where these issues exist.

Adverse Audit Opinion

An adverse audit opinion also relates to the subject matter consisting of material misstatements. However, auditors only use this opinion when those misstatements are pervasive. In other words, auditors provide an adverse audit opinion when material misstatements in the subject matter affect users' decisions. Usually, auditors express this opinion when the client is unwilling to rectify significant misstatements.

Disclaimer of Opinion

When auditors cannot obtain sufficient and appropriate audit evidence related to the subject matter, they will express a disclaimer of opinion. Usually, auditors use this opinion when the client is uncooperative or concealing evidence. However, the effect of any unavailable audit evidence must be pervasive for auditors to express a disclaimer of opinion.

Conclusion

An audit opinion is a statement expressed by auditors evaluating a subject matter against suitable criteria. There are two primary types of audit opinions that auditors may express. These include unmodified and modified audit opinions. The modified audit opinion has three types, including qualified opinion, adverse opinion, and disclaimer of opinion.

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Fallen angels investment strategy

Fallen Angel's investment strategy is a type of aggressive investment strategy, which has the potential to yield high returns. At the same time, it also entails high risk for investors. These investments are often made by venture capitalist firms in startup companies that have failed to get off the ground or need an infusion of cash to continue their operations.

Angel investors must be able to accurately assess if they intend on investing in a company with low-quality assets or not. This means looking at certain ratios such as return on equity and debt-equity ratio before making any investments, and consequently increasing their chances of success compared to other types of investing strategies. However, these ratios can only give so much information about a company's viability going forward and therefore require further research.

In this article, we are going to look at Fallen Angel's investment strategy and outline what is involved in executing it.

Fallen Angels Investment Strategy: Definition

According to Investopedia, a fallen angel refers to private equities or venture capital firms that have previously achieved strong returns but have since lost their luster because of poor subsequent performance. The term could also be described as individual investments that have underperformed and fallen out of favor with investors.

In simple terms, a fallen angel is a company that has performed well in the past only to see its fortunes reverse and start declining. The term was coined by venture capitalist Fred Wilson during the dot-com boom period between 1995-2000 and refers to companies such as Microsoft, Oracle, and Cisco Systems whose stocks were considered overvalued during the period.

How does Fallen Angels Investment Strategy Work

Like other types of investing strategies, Fallen Angel's investment strategy requires a thorough due diligence process in order to ensure that the company fulfills certain prerequisites deemed to be necessary for success. Depending on the nature of the research, this could include looking at historical financials and projections as well as examining current market trends and assessing how they will affect sales volumes going forward.

However, a fallen angel investment strategy is not just limited to researching a company's financial history.

Firstly, investors need to assess the reasons behind why the company fell out of favor in the first place. These could include low sales volumes, incompetent management decisions, high debt levels, or other related factors. After all, it is not unheard of for companies that have fallen from grace for one reason or another to bounce back and recover their initial investment value.

The next step is to determine if the company's bounce-back potential is high enough that it would justify taking on the additional risk involved in investing in a fallen angel. This involves looking at whether other companies within the same space or industry have stocks that are undervalued, as well as considering whether the company can compete with them successfully in order to improve its fortunes.

Finally, during the actual execution of a fallen angels investment strategy, investors should remain flexible and be willing to adjust their strategies as needed depending on how things are going. This means identifying new assets or opportunities that could prove beneficial for both themselves and portfolio companies when they arise.

Fallen Angels Investment Strategy Benefits

In many cases, fallen angels represent a good opportunity for investors who are willing to take on additional risks. This is because they can offer the chance to invest in some of the biggest and most successful companies in the world even if their stocks have fallen from grace due to one reason or another.

Here are some of the benefits of the Fallen Angels Investment Strategy

• If you're in the know, you can get a great deal
• Investing with a fallen angel will give you access to companies that have achieved high ROI on their investments
• You get the chance to invest in some of the biggest and most successful companies in the world
• A fallen angels investment strategy is not just limited to researching a company's financial history. They also require due diligence into whether the company has any other assets or opportunities that could prove beneficial for both themselves and portfolio companies when they arise
• Fallen angels are considered to be more undervalued as opposed to other types of stocks that have no potential
• There is less competition because investors who normally invest in them don't want to touch fallen angels with a 10-foot pole, which basically means you can get some really good deals.

Conclusion

As with all other types of investment strategies, a fallen angels investment strategy requires thorough due diligence in order to determine whether the company is suitable for investments. While fallen angels may seem like great opportunities at first glance, it's important to remember that there are always risks involved. However, don't let this discourage you from testing out your own Fallen Angels Investment Strategy because it could bring you plenty of profits.

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Audit Committee Terms of Reference Best Practice

Corporate governance is a system of practices, rules, and processes by which companies are directed and controlled. It provides a framework for companies to achieve their objectives. Corporate governance defines several rules and practices that help companies run effectively and efficiently. Among these, corporate governance requires companies to establish several committees, including the audit committee.

What is the Audit Committee?

The audit committee is a body that overlooks a company's external and internal audit functions. This committee is also responsible for ensuring the integrity of financial and narrative systems within a company. For most companies, having an audit committee is mandatory under corporate governance requirements. Other companies can also voluntarily establish an audit committee.

The audit committee reports directly to the board of directors. This committee includes independent non-executive directors, one of whom has a financial background. The duties and responsibilities of the committee may differ from one company to another. In some cases, this committee may also be in charge of risk management if a risk management committee doesn’t exist.

What are the Audit Committee Terms of Reference?

The audit committee terms of reference define the purpose or structure of the committee. Usually, it is a written document that helps set an audit committee's objectives, responsibilities, and other fundamental aspects. The audit committee terms of reference serve as a policy manual for the audit committee.

The audit committee's terms of reference will differ from one company to another. Companies may add specific portions to it or remove some others. Nonetheless, most terms of reference documents will cover some crucial areas. These include the objective of the committee, its responsibilities, its constitution, its authority, secretarial and meeting duties, the review process, reporting procedures, etc.

Usually, most of the areas within the terms of reference will take guidance from corporate governance and best practices. However, companies can modify these terms to serve their purpose. However, any modifications to the terms of reference should be in line with the corporate governance requirements. Companies must also review the terms of reference regularly and make any amendments they deem necessary.

What are the Audit Committee Best Practices?

Best practices are procedures, rules, or processes that are accepted or prescribed as being most effective. These rules can help companies understand what the benchmark for audit committees is. Best practices may come from various sources. Some of these may arise from legislation, while others may relate to a specific industry.

Following the audit committee's best practices is not mandatory for companies. However, if companies choose to adhere to these practices, they will improve the efficiency and effectiveness of their audit committees. The audit committee's best practices merely define the standard process, rules, or procedures. Companies may also use these practices as guidance to setting up their audit committees.

Audit committee best practices may define various factors. These may include the audit committee's work plan, meeting requirements, communication practices, corporate governance practices, etc. Similarly, the best practices may vary from one place to another. However, they usually cover the same areas and have similar practices.

Conclusion

The audit committee is a committee that companies must set up due to corporate governance requirements. This committee usually handles a company's internal and external audit, financial reporting, and risk management functions. The audit committee terms of reference is a document that defines various aspects of the committee's work. The audit committee's best practices are practices that are accepted or prescribed as being most effective.

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Hedge Fund Investment Due Diligence

Hedge fund investment is a type of private equity. Hedge funds are less regulated than mutual funds, and traditionally do not have the same liquidity requirements as other investments. They invest in stocks, bonds, currencies, commodities, and derivatives, which offer high-risk/high-return potential.

Due to this high-risk factor, it is important to perform extensive due diligence when evaluating a potential hedge fund investment. A lack of transparency leaves potential investors with only the information the manager wants them to know, and this creates a serious obstacle for those seeking to mitigate risk.

So let's find out what is Hedge Fund Investment Due Diligence and why it is important.

What are Hedge Funds

Hedge funds are pools of capital that are managed by an investment advisor, like a mutual fund. However, hedge funds employ a wide range of strategies and can invest in almost anything. Hedge fund managers are usually compensated with a flat fee or through performance fees (a percentage of profits).

It offers a great opportunity for professionals and retail investors to earn a high return on their investments. Everything comes at a risk, even the loss of your initial capital.

These funds are used by large and experienced professional investors with very deep pockets such as banks, insurance companies, pensions plans, endowments, wealthy families, and other qualified investors. Hedge funds have an extremely high risk and have the potential to provide higher returns.

What is due diligence

Due diligence is basically a review of all the relevant documents, reports, and other information available about a company or an investment opportunity to determine whether or not it's a good investment. It provides investors with information about the financial history and current status to determine if the investment is sound.

It helps in identifying problems that may affect future business operations so that decision-makers can take steps to avoid them.

What is hedge fund investment due diligence

Hedge fund investment due diligence is an investigation to gain the knowledge, skills, and ability required to assess a hedge fund's strategy, value, and integrity. So it may be a set of procedures that are carried out by investors before they invest in a hedge fund in order to mitigate risk.

An investor should use all available sources to learn about the manager and team before deciding whether or not to invest. The due diligence process can take weeks, if not months, in order for you to determine that the information you receive is accurate.

Importance of hedge fund due diligence

There is no doubt that investors and potential investors have started paying more attention to the due diligence process over the past couple of years. Daily news about financial scams and other scandals has made many investors realize that they need to do their research before investing their money.

Here are some points to understand why hedge fund due diligence is important

• You should carry out due diligence before investing in any investment vehicle whether it's a mutual fund, an IPO, or a hedge fund because you don't know what will come next in the market
• Hedge funds have high risk and require extensive research due diligence
• Knowledge about the hedge fund managers, funds of funds, the background is important
• Investors need to ensure that all information about their investments and other assets are accurate in order to make good investment decisions

Conclusion

It's a fact that due diligence helps investors gain knowledge and identify hidden problems within an investment. As an investor, it's your responsibility to be up to date with all the information about your investment. Here we can see that hedge fund due diligence is an extremely complicated task, but you must not give up and should never take a decision in haste.

Originally Published Here: Hedge Fund Investment Due Diligence

What is the Substantive Audit Approach

An audit approach defines the strategy that auditors use to conduct an audit. Usually, auditors use a specific audit approach for every audit assignment based on several factors. Among these approaches, some may apply to clients or engagements in different industries. One of these includes the substantive audit approach, also known as the vouching approach.

What is the Substantive Audit Approach?

The substantive audit approach is a strategy that auditors use that primarily focuses on substantive procedures. This approach requires auditors to perform more work. However, it also allows them to test the subject matter in more depth. The substantive audit approach is the opposite of the system-based audit approach, which relies on internal controls.

Auditors use the substantive audit approach to verify balances and transactions in more detail. Usually, auditors assess the client’s internal control systems first. If they believe they cannot rely on the systems in place at the client, they will choose the substantive audit approach. In other words, this approach is beneficial when auditors believe the client’s internal control systems to be inefficient.

How does the Substantive Audit Approach work?

As mentioned, the substantive audit approach begins with an assessment of a client’s internal control systems. Usually, auditors do so to decide on the audit strategy to use. If a client’s internal control systems are reliable, auditors will prefer the system-based approach to audits. On the other hand, if they can’t trust those systems, they will use the substantive audit approach.

The substantive audit approach requires more work from auditors. Since auditors cannot rely on the client’s internal control systems, they will seek to cover the audit risks through substantive procedures. These procedures primarily include a test of details and substantive audit procedures. With this approach, auditors will select a larger sample of events and transactions and test them.

The substantive approach to audits focuses on testing balances and transactions in detail. It is why it is also known as the vouching approach to audit. This approach may apply to both internal and external audits. Auditors perform thorough vouching by looking at supporting documents for all items tested. In case the client's internal controls are inefficient, this approach can be highly effective.

What are the advantages and disadvantages of the Substantive Audit Approach?

The substantive approach to audits allows auditors to test balances and transactions in detail. By doing so, they can cover a significantly higher portion of audit risks compared to other approaches. However, that is still subject to sampling risks. This approach is also one of the traditional approaches to audit and is easy to understand. Substantive audits are beneficial when auditors can’t rely on the client’s internal controls.

The substantive audit approach has some drawbacks, though. The primary one of these includes more work performed by auditors. Since this approach focuses on larger volumes of testing, it significantly increases auditors' workloads. Similarly, the substantive audit approach is not risk-focused. Some auditors consider it outdated due to the number of better alternative audit approaches available.

Conclusion

The substantive audit approach is a strategy that auditors use when the client's internal control systems are unreliable. This approach focuses on a higher volume of testing and vouching. Due to this, auditors will perform more work to cover the audit risks associated with an audit engagement. However, this approach is more traditional, and there are better alternatives available.

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Hedge Funds as Diversifiers

Hedge funds are investment pools that represent a variety of investments, including stocks and other securities. Diversification is the act of investing in multiple assets to reduce risk exposure from any one asset. Hedge funds may be an effective means for investors to increase their diversified portfolios without having to take on excessive risk.

Hedge funds can be used as a diversifier in your portfolio, but you should understand the risks and rewards before using them. So in this article, we'll discuss what hedge funds are, how they work, and what their advantages are. We will also cover some concerns about using them and talk about the costs associated with this kind of fund.

What are Hedge Funds?

Hedge funds are investment funds that include a variety of investments, such as stocks and securities.

The difference between hedge funds and mutual funds is that hedge funds offer substantial flexibility to their managers to invest in company shares or other financial instruments, such as options and futures contracts. Mutual funds have stricter guidelines on what they can invest in. This flexibility is what makes hedge funds riskier than mutual funds, but it also means that they can provide a lot of potential returns.

Managed by an individual or group, these investment pools represent a variety of investments and are typically offered only to accredited investors with extensive assets to invest.

What makes Hedge Funds different from other investments?

The degree of diversification and flexibility that hedge funds offer is what makes them different. Remember, not all financial investments are created equally. When you choose your investments, it's important to consider how these assets will contribute to (or detract from) the overall value of your portfolio over time.

Hedge funds have a reputation as high-risk, high-reward investment vehicles. The combination of the two means that they can offer higher returns than other funds that are limited in their holdings.

But let's be honest here: this is not a get-rich-quick scheme. Hedge funds are for those investors who understand both the risks and the rewards and want to use them to maximize their investment potential.

How do Hedge Funds Work?

Hedge funds pool individual investments and generally require investors to become partners with the fund manager. Investors hand over a portion of their assets, which the hedge fund uses to create a large portfolio that is then divided among many different market securities.

The goal of this strategy is for small, short-term gains to offset longer-term losses. The fund manager requires investors to lock up their funds for a specified period of time, sometimes many years.

As with any investment, there are risks involved in using hedge funds as part of your portfolio. You should be aware of these risks and willing to accept them before investing your money.

The Advantages of Hedge Funds

Here are some of the advantages of Hedge Funds:

• Hedge funds are an investment that requires a lot of research into potential risks and rewards
• Investing in hedge funds is an excellent way to balance your portfolio
• Having the ability to increase returns while managing risk makes hedge funds perfect for investors.

Disadvantages of Hedge Funds

Here are some of the disadvantages of Hedge Funds:

• Because they are speculative and high risk, hedge funds can be a poor choice for someone with a low-risk tolerance.
• Don't invest in something you don't understand. If you don't have the time or education to research and select your own investments, it's best not to use hedge funds.
• Hedge funds usually require a high minimum investment, which means that only a small number of investors can actually use them.

Conclusion

Hedge funds are a good idea to invest in if you want to make your money grow. They might be risky, but they can also help you get more money. If you are not sure what to do with your money, hedge funds can help you find the right solution. If you feel confused, you can always get help from financial advisors or other investors. But don't forget, the investment you make is your decision and it's up to you what to do with your money.

Originally Published Here: Hedge Funds as Diversifiers

Accounting For Foreign Exchange Gains and Losses

What is a Foreign Exchange Gain and Loss?

Most companies or businesses deal in various currencies due to the nature of their operations. It may include transacting with foreign suppliers or customers, overseas operations, foreign investments, etc. Usually, companies incur a gain or loss on each transaction due to variations in currency exchange rates. Therefore, any fluctuations of foreign currencies in relation to their home currency can lead to a foreign exchange gain or loss.

Usually, companies do not incur gains or losses for cash transactions. However, with credit transactions, fluctuations can lead to income or expenses. When companies complete these transactions, they will incur realized gains/losses. Sometimes, however, companies may also incur them on uncompleted transactions. These are known as unrealized gains or losses.

What is the accounting for Foreign Exchange Gains and Losses?

There are two types of foreign exchange gains or losses for which companies must account. As mentioned, these include realized and unrealized gains/losses. The accounting treatment for both of these is as below.

Realized gains/losses

Under accounting standards, companies must record every transaction at the time of occurrence. When these transactions are in foreign currency, companies must translate them to their functional currency. This currency is usually the currency used in the environment in which they operate. If the payment gets completed immediately, there will be no foreign exchange gains or losses.

However, when the settlement occurs at a different date, foreign exchange gains or losses will occur. At the time of reimbursement, a company will measure the difference between the initial value and the current value for the transaction. Any variations will result in a financial gain or loss.

For example, a company purchases goods worth £1,000 from a supplier from the UK. However, the company's functional currency is USD. At the time of the transaction, the GBP/USD spot rate is $1.25. Therefore, the accounting treatment will be as follows.

Dr Purchases $1,250

Cr Payables $1,250

After a month, the company pays its supplier. At this time, the spot rate is $1.30. Therefore, the payment will give rise to a foreign exchange loss. The accounting treatment will be as follows.

Dr Payables $1,250

Dr Foreign exchange loss $50

Cr Cash/Bank $1,300

Unrealized gains/losses

Unrealized gains/losses relate to monetary balances that are in foreign currencies. At each reporting date, companies must retranslate these balances to the year-end exchange rate. Although the transactions do not get settled until after the reporting date, companies must still recognize gains/losses for them.

For example, a company purchased goods worth €2,000. The company’s functional currency is USD. The spot rate at the time of the transaction was $1.15. Therefore, the accounting treatment at the time was as follows.

Dr Purchases $2,300

Cr Payables $2,300

At the reporting date, the company had not settled the balance. As it is a monetary balance, the company must account for any foreign exchange gains/losses. Furthermore, at the reporting date, the spot rate was $1.17. Thus, the company now owes its supplier $2,340 (€2,000 x $1.17). Therefore, the accounting treatment will be as follows.

Dr Foreign exchange loss $40

Cr Payables $40

After the reporting date, the company settles the balance. At this time, the spot rate is $1.14. Therefore, the company will realize a foreign exchange gain, as follows.

Dr Payables $2,340

Cr Foreign exchange gain $60

Cr Cash $2,280

What is the difference between accounting for Foreign Exchange Gains and Losses under IFRS and GAAP?

Both IFRS and GAAP have similar standards when it comes to dealing with foreign exchange gains and losses. There are some differences in other areas. However, for the above types of gains/losses, the accounting treatment is similar. Under both standards, companies must account for these foreign exchange gains/losses in their profit or loss accounts.

Conclusion

Companies that deal in foreign currencies incur foreign exchange gains or losses. These may be of two types, including realized and unrealized. The accounting treatment for foreign exchange gains/losses is mostly similar under both IFRS and GAAP. Companies must report these gains and losses in their income statement.

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Balance Sheet Audit Approach

With external audits, auditors examine a client's financial statements. These financial statements primarily include the balance sheet and the income statements. Usually, auditors employ an audit approach such as substantive procedures or a system-based approach for these audits. Sometimes, however, auditors may focus on the balance sheet only. In that case, they may utilize the balance sheet audit approach.

What is the Balance Sheet Audit Approach?

The balance sheet audit approach is a strategy that auditors use within audit engagements to focus on a client's balance sheet. This approach prioritizes balance sheet items, which primarily involve account balances. With the balance sheet audit approach, auditors usually perform little testing on other financial statements. However, they do not ignore the other statements completely.

The balance sheet audit approach primarily focuses on testing assertions related to account balances. These include occurrence, completeness, accuracy, classification, presentation, and cut-off. Therefore, auditors don't put a substantial amount of work toward testing transactions. This approach is particularly beneficial when the client's balance sheet includes significant balances.

How does the Balance Sheet Audit Approach work?

Like any other audit approach, auditors decide on using the balance sheet approach during audit planning. Usually, auditors investigate the client's balance sheet and the account balances on it. As mentioned, when the account balances on the balance sheet are significant, auditors may decide on using this approach.

However, auditors still use their professional judgement to determine if the account balances are substantial enough. Similarly, auditors also consider other financial statements and how they will contribute to users' decisions. If a client's income statement contains critical transactions, the balance sheet audit approach may not be practical.

Auditors must also consider the materiality set for the audit to check the balance sheet items. If most balances on the balance sheet are material, then the balance sheet approach will be effective. Once auditors consider these factors, they may decide on using this approach to focus on the client's balance sheet.

The balance sheet audit approach also works on the assumption that transactions also affect account balances. For example, it assumes that sale transactions also affect the account receivable balances on the balance sheet. Therefore, testing account receivable balances from the balance sheet can also help investigate sale transactions.

What are the advantages and disadvantages of the Balance Sheet Audit Approach?

The primary advantage of the balance sheet audit approach is that it reduces the amount of work that auditors perform. Instead of testing two or more separate financial statements, auditors only focus on a single financial statement. For capital-intensive clients, where the balance sheet includes substantial balances, this approach is usually the best.

However, the balance sheet audit approach also plays down the significance of other financial statements. By focusing on the balance sheet or account balances, auditors may miss material misstatements in transactions. Therefore, this approach may not be the best when the other financial statements also have substantial items.

Conclusion

The balance sheet audit approach is a strategy used by auditors that primarily focuses on testing account balances. It assumes that transactions also affect account balances. Therefore, by investigating those balances, auditors also test transactions. This approach works best when a client's balance sheet consists of large account balances while other statements aren't as critical.

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Equity Long Short Hedge Funds

The investment objective for each investor may differ. However, most investors have one common goal, to increase their wealth. For that, they employ investment strategies that meet their requirements. There are many of these strategies that provide investors with different options. One of these includes the equity long-short investment strategy.

What is the Equity Long Short strategy?

The concept of the equity long-short strategy is straightforward. It involves going long on investments that investors expect to grow in value. Similarly, it includes shorting investments that investors believe will suffer in the future. In other words, the equity long-short strategy involves buying investments with high growth potential. In contrast, it also requires investors to sell investments that they expect to decrease in value.

The equity long-short strategy requires investors to employ both the long and short investment strategies simultaneously. This strategy allows investors to hold onto investments that will increase in value in the future. By doing so, it ensures future profits for investors. However, it also requires investors to sell their assets when the value decreases. This way, investors can avoid making any future losses.

Most investors, either deliberately or unintentionally, use this strategy as a part of their portfolio strategy. The equity long-short strategy aims to provide investors with absolute returns. Generally, this strategy leans towards either the long or short side based on how investors view their investments. The equity long-short strategy is more prevalent among hedge funds and mutual funds.

What are Equity Long Short Hedge Funds?

Equity long-short hedge funds are funds that use the long-short approach to investing. Most equity hedge funds in the market are currently utilizing this strategy. These hedge funds increase investors' wealth through both long and short investment strategies. Together, these strategies can help hedge funds achieve better gains while also reducing the market risk for investors.

As with other hedge funds, equity long-short hedge funds also get managed by fund managers. These managers may focus on specific industries or markets. Some managers also specialize in particular categories of investing. The performance of these hedge funds also depends on how fund managers handle a fund's operations. In exchange for their services, these managers receive a fee.

How do Equity Long Short Hedge Funds work?

Equity long-short hedge funds generate profits in two ways. First, these funds identify opportunities to acquire investments when the prices are increasing. By going long on these stocks, equity long-short hedge funds can ensure they will generate returns in the future. Therefore, fund managers need to identify investments that they deem to be underpriced in the market and acquire them.

Second, these funds also exploit investments with adverse price movements. By going short on those stocks, these hedge funds ascertain investors make profits in the future. For that, fund managers need to identify investments that they deem to be underpriced in the market. As mentioned, some hedge funds may have a bias towards either the long or short side. Therefore, fund managers may lean towards either side based on their preference.

Conclusion

Equity long-short investment strategy has two sides. The first side includes going long on investments that investors believe to generate value in the future. The second involves going short on overpriced investments. Equity long-short hedge funds employ this strategy to generate returns for investors. These funds have managers that dictate how they perform in the market.

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Risk-Based Approach to Audit

Auditors must consider the audit risks associated with audits. It is crucial that they reduce these risks to an acceptable or reasonable level. However, most traditional audit approaches overlook audit risks. While these approaches still cover most risks, they are not suitable for risky audits. For these audits, auditors need to use a different audit approach, known as the risk-based approach.

What is the Risk-Based Approach to Audit?

The risk-based approach to audit is one of the most prevalent audit approaches. This approach focuses on analyzing and managing different risks that can give rise to material misstatements. As mentioned, this audit approach is most useful when used for risky audits. The risk-based approach to audit allows auditors to direct their work toward covering risk areas of the subject matter.

The risk-based audit approach aims to address the highest priority risks that may exist in an audit engagement. However, that does not imply that auditors completely neglect less risky areas. This approach is usually prevalent in internal auditing. However, external auditors can also employ it for their audits. The most critical stage within the risk-based approach to audit is the planning stage.

How does the Risk-Based Approach to Audit work?

The risk-based approach to audit commences from the audit planning stage. Before employing this approach, auditors need to obtain a fundamental understanding of the client's high-priority risks. During this approach, auditors need to consider every department and process individually. The risk-based approach seeks to address the top risks for each area and provide insights to the client.

After identifying the risks, auditors must also assess the impact that those risks can have on the subject matter. This process is subjective and requires the auditor's professional judgement. Auditors need to consider various factors when assessing the impacts of the identified risks. However, the most critical of these will be the effect these risks have on the financial statements.

Once auditors identify and assess the risks, they can plan their audit procedures accordingly. After executing their plan, auditors will have to report to the users. For internal auditors, the process will also involve providing recommendations and following up on those risks. With external audits, the primary objective will be to manage risks and reduce them to an acceptable level.

What are the advantages and disadvantages of the Risk-Based Approach to Audit?

The risk-based approach to audit has several benefits. The most crucial of these is allowing auditors to manage the risks associated with their audit engagements. This approach provides benefits that other traditional audit approaches fail to consider. The risk-based approach to audit primarily applies to internal audits. This approach can also reduce the level of work auditors perform while maintaining audit quality.

Risk-based audits may also have some drawbacks. Most importantly, this approach does not focus on low-risk areas. While it can result in time-saving, it may result in material misstatements being neglected. Risk-based audits are also subjective. If auditors fail to make the correct judgements, the audit quality may get affected. Similarly, this approach may not be suitable for all audit types.

Conclusion

Risk-based audits involve using an audit approach that focuses on high-priority risks. This audit approach is most common within internal audits. The risk-based approach to audit requires auditors to identify and assess the risks that the clients face. Based on that, they can then develop an audit plan. This approach primarily focuses on managing and minimizing audit risks.

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Factor Investing Through Principal Component Analysis

Factor investing is a well-known investment approach used mostly by quant funds. Even though the factors are well published, it’s important to distinguish 2 types of factors:

• Explicit factors: these are for example momentum, value, size, quality, etc.
• Implicit factors: these are statistical features determined by using e.g. maximum likelihood, Principal Component Analysis (PCA).

Thanks to their statistical nature, the implicit factors are often easier to calculate. However, we often don’t know what they exactly are, and we need to use intuition and statistical techniques in order to assign sensible economic variables to them. For example, in fixed income, the first eigenvector (factor) can be interpreted as the level of the interest rate, while the second one would be the slope of the yield curve. Similarly, in the volatility space, the first eigenvector would be associated with the volatility level, while the second one would be the volatility skew.

Applying Principal Component Analysis to a basket of stocks and assigning sensible market variables to the eigenvectors is, however, less trivial. The first eigenvector is usually the market level, but the second and higher ones often carry no meaning and/or are difficult to interpret.

To mitigate this problem, Reference [1] proposed a so-call Hierarchical Principal Component Analysis (HPCA), a variant of the PCA method in which stocks are divided into clusters that are believed to share common features such as an industry sector, a country, or a statistical measure,

To mitigate this problem and account for hidden risk factors, we adopt a purely statistical technique. This is a simple and still powerful tool that dynamically adapts to changes in market conditions over time, which makes it suitable for managing trading portfolios. Also, it is a parsimonious approach since it does not rely on too many parameters. The user only needs to define the number of clusters, which depends on the number of K eigenvectors, without specifying any other parameters or hyper-parameters

Using this statistical clustering technique, the authors developed an investment portfolio and managed to outperform the market,

To illustrate an application, we show it in the context of portfolio optimization for the US stock market. We provide evidence that using HPCA statistical-based factor models outperform other classical portfolio construction methodologies such as the shrinkage covariance matrix and the HPCA GICS-based factor models.

We find that it makes sense to use statistical features to partition stocks into clusters. We believe, however, that the traditional PCA can also be used, in conjunction with common sense and intuition, to identify clusters; e.g. we were able to use the second eigenvalues to divide utility stocks into regulated/unregulated groups. Similar results were also obtained in the fixed income space.

References

[1]  M. Avellaneda and JA. Serur, Hierarchical PCA and Modeling Asset Correlations (2020). https://ssrn.com/abstract=3903460

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What is System Based Audit

When auditors commence an audit engagement, they must decide on what audit approach to use. The audit approach is a strategy auditors use to perform audits. This approach differs based on several factors and will vary for each audit engagement. There are several audit approaches that auditors may employ. One of these includes the system-based audit approach.

What is the System-Based Audit Approach?

A system-based audit approach is an audit approach that relates to a client's internal controls. With this audit approach, auditors rely on a client's internal control systems to conduct the audit. For that to be possible, the auditors must establish that the internal control systems at the client are appropriate and sufficient. This approach takes an opposing strategy to audits compared to the substantive procedures audit approach.

The system-based audit approach to auditing focuses on testing a client's internal control systems. When auditors can rely on those systems, they may assume that the client's financial reporting system will also be less risky. However, that does not imply that the system-based audit approach won't require further work beyond testing internal control systems.

How does the System-Based Audit Approach work?

The system-based audit approach starts with the auditors studying a client's internal control systems. Auditors must obtain an understanding of the client's operations and fundamental control systems. Most importantly, they must assess the internal controls related to financial reporting. Auditors must determine how effective these internal controls are in preventing, or detecting, and correcting misstatements.

The primary procedure that auditors use during system-based audits is the test of controls. It is a procedure through which auditors assess two aspects of the client's internal controls. The first relates to whether controls exist where they should. The second relates to whether those controls are effective in achieving the expected outcomes.

If auditors conclude that the internal control systems at the client are effective, they can use the system-based approach. However, if those systems are inadequate or ineffective, auditors cannot perform a system-based audit. Nonetheless, that does not conclude the work that auditors perform under this approach.

While system-based audits focus on internal controls, auditors still need to test additional areas. However, the threshold for testing may be more lenient compared to other audit approaches. The initial findings from assessing the internal controls help auditors determine the level of substantive tests that auditors need to perform. The higher the trust that auditors can put on the client's internal control systems, the lower the substantive tests carried out will be.

What are the advantages and disadvantages of the System Based Audit Approach?

The system-based audit approach provides auditors with several advantages. This approach allows auditors to reduce their workload. Therefore, it can help auditors save time and focus on more critical areas. This approach can also reveal deficiencies with the client’s financial reporting systems.

However, the system-based audit approach has some limitations as well. One of the most crucial of these is not focusing on risks. When it comes to audit engagements that auditors consider risky, the risk-based audit approach is more suitable.

Conclusion

Auditors can use one of many audit approaches for their audit engagements. One of these includes the system-based audit approach, which focuses on a client’s internal control systems. With this approach, auditors can reduce the time it takes to complete audits. However, system-based audits may not be relevant to risky audits.

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Global Macro Hedge Funds

A country's economy plays a significant role in the prices of items within it. The economic factors in a nation also dictate the investments market. Most security prices fluctuate with fluctuations in a country's economic environment. Some investors may take advantage of these fluctuations and base their investment strategy accordingly. One such strategy is the global macro strategy.

What is the Global Macro Strategy?

A global macro investment strategy studies a nation's macroeconomic events and adjusts investments accordingly. In some cases, this strategy may also apply to a region or globally. The global macro strategy is prevalent in hedge funds or mutual funds. Using this strategy, fund managers study a country's political and economic circumstances. Based on their findings, they make decisions.

The global macro strategy requires investors to take an active approach toward investing. Usually, they need to review various macroeconomic and geopolitical factors to adjust their portfolios. These factors may include interest rates, inflation, forex rates, political events, etc. With the global macro strategy, investors can diversify their portfolios against market risk.

What are Global Macro Hedge Funds?

Hedge funds involve using pooled funds to invest in various assets. These funds usually use aggressive investment strategies to generate income for investors. Hedge funds employ several investment strategies based on their goals. Global macro hedge funds use the global macro strategy to manage investors' portfolios actively. Similarly, these funds use the global macro strategy as their primary investment strategy.

Global macro hedge funds actively track market conditions to identify any opportunities to profit. These funds look at a country’s economic and political conditions to make decisions regarding investments. Global macro hedge funds base their decisions around economic events. Like any other funds, these funds also have managers that actively manage investors’ pooled funds.

Global macro hedge funds are more lenient in their investments. They usually invest in a broader asset range globally. These funds may include holdings currency strategies, commodities, fixed income, long/short positions in equities, etc. However, there is no particular investment style these funds follow. Instead, it depends on each fund manager’s preference.

How do Global Macro Hedge Funds work?

Global macro hedge funds do not limit their investments to specific sectors, markets, or nations. Instead, they include a broad range of assets in their portfolio. Before making investments, these funds consider various factors, such as interest rates, political conditions, currency exchange rates, etc. However, the exact strategy will depend on the fund managers.

Global macro hedge funds make investment decisions based on macroeconomic factors. For that, managers need to study those factors actively and identify profit opportunities. However, these funds do not follow trends. Instead, they make detailed analyses based on their expertise and experience. Their analysis is fundamental to the success of global macro hedge funds.

Global macro hedge funds also focus on including liquid investments in their portfolio. Therefore, most of these funds participate in markets with high liquidity. Having a broad range of assets to choose from also helps them in this regard. On top of that, this strategy allows greater diversification due to the same reasons.

Conclusion

Economic factors play a significant role in the investment market. The global macro strategy is an investment strategy that bases investment decisions on macroeconomic and political factors. Global macro hedge funds use this strategy to build a profitable portfolio. These funds invest in a wide range of assets without any restrictions. However, they consider all macroeconomic factors before making decisions.

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How to Determine Materiality in Audit

Auditors do not provide absolute assurance for audit assignments. It is because they cannot test every single transaction or balance. Usually, auditors work with limitations, such as time, which require them to complete their work before a specific time. However, they still need to test items that they may consider to be material.

What is Materiality in Audit?

Materiality refers to a threshold set by auditors relating to the importance of amounts in a subject matter. It expresses the importance of the underlying matter in terms of the impact on users’ decisions. Usually, auditors specify this amount during the planning process. Based on the audit materiality, auditors determine whether they should test a balance or transaction.

Auditors may consider several factors when determining the materiality in an audit engagement. These factors may relate to the size of the tested item or its nature. While there is some guidance for choosing the materiality for an audit, they still have to use their judgment. Therefore, materiality is a subjective matter and may differ based on specific circumstances.

How to determine Materiality in Audit?

As mentioned, auditors must consider various factors when determining the materiality in audit engagements. It relates to how misstatements in the subject matter affect the economic decisions made by users. Therefore, auditors must primarily focus on setting materiality based on the impact on users' decisions.

On top of that, auditors must also consider the size and nature of any amounts or misstatements. Some items in the subject matter may not be of significant size. However, they will still be material, based on their nature. For example, amounts relating to compliance with regulatory requirements are inherently material.

Lastly, auditors must also consider the information needs of the users as a group. These factors also play a significant role in determining materiality in audit as different groups may have varying needs. Overall, auditors must use their professional judgment and determine the materiality level for an audit engagement. Usually, however, auditors set a benchmark based on the size of items in the subject matter.

How to determine Materiality level based on size?

In most cases, auditors use several benchmarks to determine the materiality based on size. These benchmarks include revenues or expenses, total assets, and net profit before tax. Usually, auditors use one of these to set a materiality level for an audit engagement. However, they may also use a combination of these.

Once auditors choose a benchmark, they must determine a level for it. There is no specific guidance related to what this level should be. However, there are generally accepted levels that auditors often use. These are as below.

• 5%-1% of total revenues (or expenses).
• 1%-2% of total assets.
• 5%-10% of net profit before tax.

Auditors can also calculate the materiality level under all these categories. Once they do so, they can select a materiality level that they deem appropriate based on their judgment. Based on this level, auditors can also determine the performance materiality in an audit engagement.

Conclusion

Materiality is a crucial concept in audit engagements. It defines a benchmark that allows auditors to determine whether they should test a given subject matter item. Auditors must consider various factors when determining materiality in an audit engagement. Usually, auditors use a benchmark to set a materiality level. However, the process is subjective and requires auditors to exercise their professional judgment.

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What are Event-Driven Hedge Funds

Investment strategies include principles that seek to achieve an investor's financial and investment objectives. These strategies may differ from one investor to another based on various factors. These factors may include the investor's goals, resources, time horizon, risk tolerance, etc. Similarly, some investment strategies may also depend on specific circumstances or events, for example, event-driven strategies.

What are Event-Driven Strategies?

Event-driven strategies are investment strategies that seek to exploit specific circumstances to gain returns. These strategies take advantage of specific occurrences where an opportunity to profit exists. Similarly, investors use event-driven strategies where there are one-off circumstances in the market. For example, an over- or under-valuation of a company's stock prices in the market for a short time can stimulate the event-driven strategy.

Event-driven strategies can allow investors to make significant profits before the underlying events are over. However, it requires them to be aware of the occurrence of such circumstances. Therefore, these strategies need investors to be active. On top of that, it also requires them to have expertise in identifying such opportunities. In the absence of these requirements, investors may miss those opportunities or bear losses.

In some circumstances, investors may not even employ event-driven strategies. Instead, they may come across an event that will allow them to exploit it to their advantage. In these cases, investors may use the event-driven strategy, although they follow another investing strategy. Overall, these strategies seek to identify one-off events and generate returns for investors.

What are Event-Driven Hedge Funds?

Most regular investors do not use event-driven strategies. However, these strategies are prevalent among hedge funds or private equity funds. Hedge funds are alternative investments that collect funds from investors and employ various investments strategies. These funds usually have specific objectives based on which they choose their investment strategies.

Event-driven hedge funds, as the name suggests, are hedge funds that employ the event-driven investment strategy. Within this strategy, hedge funds identify specific events and exploit those to their investors’ advantage. These events generally relate to market inefficiencies that do not allow all investors access to complete information.

Event-driven hedge funds also identify highly complex events. Due to the lower understanding that other investors have, these funds can significantly outperform the market. For example, when a government introduces new regulations, the event-driven strategy can be highly impactful. While other investors may not understand how these regulations will affect their investments, event-driven hedge funds can profit.

How do Event-Driven Hedge Funds work?

Event-driven hedge funds rely on specific events occurring to make profits. These events may relate to mergers and acquisitions, financial distress, reorganization, restructuring, etc. Furthermore, these funds need to have the expertise to identify these events to generate returns. Once they do so, they carry out their due diligence and invest in the underlying company causing such events.

Event-driven hedge funds employ individuals with high expertise to identify any exploitable events. Known as fund managers, these individuals understand how certain occurrences will affect the market. Based on that, they make decisions to buy or sell investments. If their identification of such events materializes, they can generate significant income for investors.

Conclusion

Event-driven investment strategies are prevalent among hedge funds or private equity funds. These strategies aim to identify events that can generate significant returns for investors. Event-driven hedge funds include a team of highly specialized experts that can identify profitable events. By doing so, they can exploit market inefficiencies and provide high returns to their investors.

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What are the Types of Audit Approaches

What is an Audit Approach?

The term audit approach defines the strategy that auditors use when conducting an audit. It allows auditors to perform their tasks effectively and efficiently. The audit approach may differ based on several factors. These factors may include the nature of the client and its industry, the scope of the engagement, the adequacy of internal controls at the client, etc.

The audit approach differs from one audit engagement to another. Auditors must use their professional judgment to determine the focus area for an audit. Based on that, they must select an audit approach that allows them to meet their objectives. Once they consider all the relevant factors, they can choose from one of the four primary audit approaches.

What are the types of Audit Approaches?

There are several types of audit approaches that auditors can employ during audit engagements. However, four primary approaches are prevalent among most auditors. A brief description of each of these is as below.

Substantive procedures audit approach

The substantive procedures audit approach involves the use of substantive procedures to conduct audits. These procedures usually include the test of controls, the test of details, and substantive analytical procedures. This approach to auditing is often used when the auditor determines the client's internal controls to be weak.

The substantive procedures audit approach places low or no reliance on the client’s internal controls. Therefore, auditors usually have to perform more work as a result. Another name used for this approach is the vouching approach.

System based audit approach

The system-based audit approach takes a different approach compared to the substantive procedures approach. Auditors use this approach when they determine the client's internal controls to be reliable. By using this approach, auditors can significantly reduce the substantive testing required to conduct audits.

With the system-based audit approach, auditors usually prioritize testing and validating the client's internal control systems. However, auditors still need to perform substantive procedures to support their initial findings.

Risk-based audit approach

In some cases, auditors may focus more on the risks associated with a specific audit engagement. The risk-based audit approach allows auditors to focus more on high-risk areas. By doing so, auditors can cover the risks associated with an audit engagement. As a result, they may also perform lesser work and still meet their audit objectives.

However, the risk-based audit approach may also neglect low-risk areas. Despite that, it is a beneficial audit approach that can be useful in risky audits. For this approach to be successful, auditors need to study the client and relevant audit risks.

Balance sheet audit approach

As the name suggests, the balance sheet audit approach primarily focuses on the client's balance sheet. With this approach, auditors emphasize testing account balances rather than transactions. This approach assumes that testing account balances allows auditors to check any transactions that contribute to those balances.

In some cases, auditors may still check income statement items. The testing involved for those items is usually a low priority. Nonetheless, the balance sheet audit approach focuses more on material balances that exist in the balance sheet.

Conclusion

Auditors use an audit approach to conduct their audit engagement efficiently and effectively. The audit approach may differ based on several factors. There are four primary types of audit approaches that auditors may utilize. These include the substantive procedures, system-based, risk-based, and balance sheet audit approaches.

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Using an Autoregressive Model to Predict the Price-to-Earnings Ratio and Develop an Investment Strategy

In a previous post, we highlighted an article that showed how useful accounting numbers are. In this post, we will present a concrete example of an application of accounting numbers in portfolio management.

Reference [1] showed that the Price-to-Earnings ratio is a mean-reverting process, and it can be accurately estimated by AR(1), an econometric model. Earnings, on the other hand, follow a trend process and can be modeled by a first-order integrated process with a constant factor that captures relative earnings growth.

I propose a model of expected returns by decomposing stock price into two constituents: earnings and price-to-earnings (PE) ratio. The PE ratio is a mean-reverting process that can be forecasted for short to medium horizons. On the other hand, earnings follow a trend process and can be characterized by a first-order integrated process. Growth in earnings is responsible for the growth of stock prices, but the cyclical nature of the PE process imparts time-series predictability to prices.

After calibrating the models, the author constructed a long-only investment strategy that switches between stocks and bonds.

Using the expected return model, I propose a portfolio switching strategy where investor switches between stocks and bonds based on current expected returns on market-wide stock index and risk-free government bond yields. My strategy provides better risk-adjusted returns by avoiding equity investments in periods of low expected returns. The strategy is suitable for retail investors because it only involves market-wide stock index and bond yield. Moreover, my strategy does not require short-selling of stocks which can be difficult for retail investors.

In short, accounting numbers can be used in econometric models in order to develop an asset allocation strategy that offers better risk-adjusted returns.

The article showed that Earnings and Price-to-Earnings ratio have practical and useful applications. In our opinion, revenue and revenue growth are also important accounting numbers that can be used effectively in portfolio management.

References

[1]  N. Vidhani, Return Predictability using Price-to-Earnings Ratio, 2021,  https://ssrn.com/abstract=3910641

Article Source Here: Using an Autoregressive Model to Predict the Price-to-Earnings Ratio and Develop an Investment Strategy

Accounting for Mortgage-Backed Securities

What are Mortgage-Backed Securities?

Mortgage-backed securities (MBS) are financial instruments that have similar characteristics as bonds. These securities use mortgages or a collection of mortgages as collateral. Like other financial instruments, MBS also gets traded in the market. Mortgage-backed securities are a type of asset-backed securities and allow investors to deal in mortgages. Through these, investors can invest in mortgages, which is usually not possible otherwise.

Through mortgage-backed securities, investors get the right to receive the value of a group of mortgages. However, they also undertake the risks associated with those mortgages. MBSs also provide financial institutions with an advantage to raise more capital to invest in mortgages. Financial institutions providing these securities bundle various mortgages together through the process of securitization.

Securitization serves as a base for mortgage-backed securities or asset-backed securities. This process allows issuers to market their illiquid assets or securities to investors. It also provides them with the opportunity to raise more capital and alleviate their credit risk. The accounting for mortgage-backed securities is similar to financial instruments based on securitization.

What is the accounting for Mortgage-Backed Securities?

When accounting for mortgage-backed securities, buyers treat it like any other financial instrument. The accounting treatment for mortgage-backed securities differs between IFRS and GAAP.

IFRS accounting treatment for Mortgage-Backed Securities

When a reporting entity acquires MBS, it must treat it as an investment. Under IFRS, buyers must ensure the securities meet two tests. The business model test relates to the objective of holding these securities. The cash flows' characteristics test looks at whether the cash flows from the security include payments of interest and principal amounts.

Mortgage-backed securities meet both of these tests. IFRS 9 requires reporting entities to treat these securities under the amortized cost model. Initially, reporting entities must recognize these securities at fair value plus transaction cost. Therefore, the accounting entries for the initial recognition will be as follows.

Dr Mortgage-backed securities

Cr Cash/Bank

Subsequently, reporting entities must account for these securities under amortized cost. This method will include recording any interest and principal payments received from the instruments. Any interest received from mortgage-backed securities will be considered income for the reporting entity. The accounting treatment for interest from these securities will be as follows.

Dr Bank/Cash

Cr Interest Income

Any principal repayments will be similar. However, they will not be an income but rather a reduction in the value of the mortgage-backed security on the balance sheet. If these securities do not match the tests outlined by IFRS, reporting entities must treat them under the fair value model.

GAAP accounting treatment for Mortgage-Backed Securities

Under GAAP, reporting entities must report mortgage-backed securities at the current value rather than historical cost. However, establishing a fair value for MBS is challenging due to the absence of observable inputs. Therefore, mortgage-backed securities fall into the Level 3 categorization of assets established by FASB 157.

Level 3 assets are the least marked to market of the categories. Therefore, reporting entities must base their measurements on models and unobservable inputs. This process can increase the volatility of the current value between two reporting periods. Therefore, GAAP requires reporting entities to reconcile the opening and closing balances for level 3 assets. On top of that, there is a more stringent disclosure requirement for these assets.

Conclusion

Mortgage-backed securities are securities that include a mortgage or a collection of mortgages as collateral. These securities are a variation of asset-backed securities. They use securitization as a basis. The accounting for mortgage-backed securities under IFRS requires entities to record it at amortized cost. However, it may also allow for fair value measurement. Under GAAP, these securities are a level 3 asset and are recognized at fair value.

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What are Liquid Alternatives

The conventional investment categories, i.e., stocks, bonds, and cash, can provide high returns. However, piling these up can be highly risky for investors. Therefore, some investors usually go beyond these investment categories to diversify their portfolios. However, they may lose some benefits that these investments provide, such as liquidity. For that, investors may look into liquid alternatives. However, it is crucial to understand what alternative investments are first.

What are Alternative Investments?

Alternative investments are assets that do not fall into the conventional investment categories. Therefore, these include investments that are not stocks, bonds, or cash. Instead, alternative investments may consist of private equity, real estate, commodities, etc. However, these investments are more suitable for wealthy investors rather than normal ones.

Alternative investments provide investors with a great opportunity to diversify their portfolios. They aren't a part of conventional categories and, therefore, can decrease the risks that investors undertake. However, alternative investments do not get traded frequently on the market. For that reason, investors consider them to be illiquid. However, liquid alternatives change that.

What are Liquid Alternatives?

Liquid alternatives, or liquid alts, are alternative investments that are liquid. These may include mutual or exchange-traded funds. Usually, liquid alternatives provide the same benefits that most other categories of alternative investments do. However, they also have a higher trading frequency, meaning investors can buy and sell them easily. Therefore, they are more liquid.

Liquid alternatives also provide other benefits to investors. Usually, these investments require lower capital than typical investments. Similarly, they are more widely available to investors of all categories. Some alternative investments may only be available to wealthy or accredited investors. However, the same does not apply to liquid alts.

How do Liquid Alternatives work?

Liquid alts provide investors with alternatives to conventional investment categories. However, they also focus on allowing investors to acquire liquid investments. The primary reason for that includes the frequency with which these investments get traded. While not at the same level as conventional investment categories, this frequency is high enough to allow investors to invest without restrictions.

As mentioned, liquid alts include hedge or mutual funds. These funds may employ various investment techniques that differ from other funds. For example, fund managers may use long/short investing, derivatives, leverage, etc., to maximize the returns they generate for investors. However, they will still focus on providing investors with diversification and liquid investments.

What are the drawbacks of Liquid Alternatives?

Liquid alternatives provide features such as diversification or liquidity. However, they also come with some drawbacks. These investments usually offer lower returns compared to conventional investment categories. This drawback also relates to alternative investments. Furthermore, hedge funds may limit the period for which investors can withdraw or deposit their money. This limit may be counterintuitive to the liquidity these investments offer.

Similarly, liquid alternative funds usually charge higher fees compared to others. It may not be ideal for investors looking for inexpensive alternative investments. Some funds may also include investments in non-liquid assets, which counteracts the advantages investors can get. Lastly, the demand for liquid alts has increased over the years, which has resulted in slowed market growth.

Conclusion

Alternative investments allow investors to choose from investments beyond the conventional categories. However, they are not as liquid, which can be a drawback. Liquid alternatives are alternative investments that allow investors to counteract that problem. These investments get traded more frequently and are, therefore, more liquid. However, that has some drawbacks.

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Accounting for Credit Default Swaps

What are Credit Default Swaps?

A credit default swap (CDS) is a financial instrument that allows investors to exchange their credit risk with another party. It is a type of swap, which is a financial derivative. Credit default swaps require one party to acquire a CDS from another party. It ensures that the seller will reimburse the lender in case the borrower defaults.

Credit default swaps are common credit derivatives. Usually, insurance companies, banks, or hedge funds provide these swaps. In exchange for these instruments, these parties collect a premium from the buyer, usually each quarter. This way, both parties get to benefit from the transaction.

Credit default swaps are financial instruments, more specifically financial derivatives. They can help parties hedge their risks by swapping them. Therefore, they are also hedge instruments. The accounting for credit default swaps falls under hedge accounting. For entities following IFRS for reporting purposes, IFRS 9 will apply. On the other hand, ASC 815 provides guidance on how to account for CDS under GAAP.

What are the accounting treatments for Credit Default Swaps?

As mentioned, two accounting standards provide guidance on how entities should account for credit default swaps. The treatments under both of these are as below.

IFRS accounting treatment for CDS

IFRS 9 provides three categories for reporting entities to report their financial assets. These include amortized cost, fair value through other comprehensive income, and fair value through profit or loss. Similarly, the standard provides criteria for the first two categories. Financial assets that do not fall under these categories will fall under the fair value through profit or loss treatment.

Credit default swaps do not match the criteria for the first two categories. Therefore, reporting entities must account for these derivatives under the fair value through the profit or loss model. Initially, entities must record these swaps at fair value. Any transaction costs under this treatment must be treated as an expense. However, entities may elect to apply hedge accounting by designating the CDS as a hedging instrument in an eligible hedging relationship.

Under the fair value through profit or loss treatment, entities must remeasure the fair value of the CDS at each reporting date. Any differences in the fair value will become a part of the income statement or the statement of profit or loss. In case of fair value gain, the accounting treatment will be as below.

Dr Credit Default Swap

Cr Profit or Loss

In case of a loss, the accounting entries will be as below.

Dr Profit or Loss

Cr Credit Default Swap

GAAP accounting treatment for CDS

The accounting treatment for credit default swaps under GAAP is similar to the IFRS. ASC 815 requires reporting entities to record CDS on the balance sheet as an asset or liability. Furthermore, it entails that the entity must measure it at fair value with changes in the fair value reported in earnings. However, if the entity designates a qualifying hedge relationship, it can choose otherwise.

Under this approach, the accounting treatment and entries will be similar to the IFRS. Therefore, the above double entries will also apply in this case.

Conclusion

Credit default swaps are financial instruments through which an entity can hedge its credit risk. Usually, there are two parties involved in the financial contract. The accounting for credit default swaps is similar under IFRS and GAAP. Both standards require reporting entities to measure any changes in the derivative’s fair value in the income statement through earnings.

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How Do Funds of Funds Work

Investing in stocks, bonds, cash, and other asset classes is prevalent among investors. Usually, they make these investments themselves or through investment advisors. Some investors may also pool their capital and invest it into a fund. These funds have managers that make investments on their behalf. These may include hedge funds, mutual funds, etc. Like other investments, investors can also pool their capital to invest in funds.

What are Funds of Funds?

Funds of funds (FOF) involve investors pooling their capital together to invest in other funds. These are multi-manager investments that include funds as their underlying investments. Conventional funds invest in various asset classes on investors' behalf. Funds of funds, on the other hand, invest in those funds. In short, these funds manage a portfolio for investors that include other funds.

Funds are a type of investment for investors. Since investors can invest in funds, it is also possible for other funds to do so. Usually, funds of funds include investments in hedge funds or mutual funds. Through this process, investors can achieve better diversification compared to investing in those funds directly. Therefore, investors can reduce the risks involved with their portfolios while also getting similar results.

How do Funds of Funds work?

The strategy that funds of funds use may differ from one fund to another. Usually, these funds work similarly to others. They identify various investments that they believe can maximize their investors' wealth. However, these investments do not include traditional assets, i.e., stocks, bonds, cash, etc. Instead, they consist of other funds that invest in those conventional asset classes.

Funds of funds also have an asset allocation strategy. Based on this strategy, they include various funds that focus on stocks, debts, or other securities. FOFs may exist as hedge funds, private equity funds, or mutual funds. These funds may include investments in both domestic and foreign markets. Usually, FOFs employ highly competent managers to get the best output.

The primary objective for funds of funds is diversification. However, these funds also focus on identifying appropriate investments that can meet their investment goals. They allocate assets across a wide range of fund categories. Some FOFs may be fettered, while others are unfettered. Fettered FOFs invest in portfolios managed by a single investment company. In contrast, unfettered FOFs invest in funds outside their offerings.

What are the benefits and drawbacks of Funds of Funds?

Funds of funds are a great option for investors looking to invest in funds but cannot do so. Through FOFs, investors can allow qualified managers to make investments on their behalf. Similarly, they can achieve better diversification compared to investing in a single fund. Therefore, they can reduce their exposure to risk while not sacrificing a great deal on returns.

However, having a qualified manager making decisions on investors’ behalf can be costly. Usually, investors have to pay higher fees when investing in funds of funds. Some managers may also take unwanted risks to increase their performance-based fees, which is not optimal for investors. Similarly, while not significant, they lose some gains compared to if they invest in funds directly.

Conclusion

Funds of funds are pooled funds that invest in other funds. These funds, usually structured as mutual or hedge funds, employ a professional manager to make these investments. FOFs are highly favourable investments for investors that want to reduce their risks through diversification. However, they also come with some drawbacks, as stated above.

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