Auditing &
Assurance
Services,
6e
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Chapter 10
Finance and Investment Cycle
“Credit has done a thousand times more to enrich mankind than all
the goldmines in the world. It has exalted labor, stimulated manufacture
and pushed commerce over every sea.”
--Daniel Webster
10-2
Learning Objectives
1. Describe the finance and investment cycle,
including typical source documents and controls.
2. Give examples of tests of controls over debt and
stockholders’ equity transactions and investment
transactions.
3. Describe substantive procedures for finance and
investment accounts.
4. Describe common errors and frauds in the
accounting for capital transactions and
investments, and design audit and investigation
procedures for detecting them.
10-3
INVESTING AND
FINANCING CYCLE
• Concerned with transactions related to the
use of the organization's funds (investing)
and sources of those funds (financing) other
than operations.
• Accounts affected by investing and
financial cycle transactions include
investments in securities; notes and bonds
payable; and, stockholders' equity accounts.
10-4
Inherent Risks
•
•
•
•
•
Lease Accounting
Loan covenants
Related-party transactions
Complex transactions
Impairments
10-5
Exhibit 10.1 Finance and
Investment Shenanigans
10-6
Investment and Finance
Activities
•
•
•
•
•
•
Financial Plan
Capital budget
Raise capital
Operate business (all other cycles)
Mergers and acquisitions
Investment of excess funds
10-7
Exhibit 10.3
Finance and Investment Cycle
10-8
Control Considerations
• Transactions authorized by BOARD OF DIRECTORS
• Documentation:
– Investments in securities
• Broker advice for all transactions
– Property, plant and equipment
• Vendor’s invoice for purchased PPE
• Internal cost records for company-built PPE
– Bonds and notes payable
• Documentation from debtholders
– Stockholders' Equity:
• Documentation from registar
• Show me the money!!
– trace transactions to cash receipts and disbursements journals
10-9
Finance and Investment Cycle:
Control Procedures
• Physical Controls
– Securities CUSIP numbers recorded
– Securities recorded in the client's name
– Securities held
• by an independent custodian i.e. by the broker
• or in a secure location e.g. safe deposit box
– Access to safe-deposit box requires more than one
employee (dual control)
– Physical items periodically compared to detail
records
– Cash receipts from transactions deposited intact and
daily (electronic transfer preferred)
10-10
Finance and Investment Cycle:
Control Procedures (cont.)
• Separation of Duties
– Transactions AUTHORIZED by the Board of
Directors
– General Accounting RECORDS transactions
– A separate function or external custodian has
CUSTODY of stock and bond certificates
• Performance Reviews
– Compare current finance and investing transaction
data against prior-year data or expected data
– Compare revenue and expenses against
organization standards or expectations.
– Compare transactions on monthly statement to cash
receipts/disbursements
10-11
CONTROL OVER
ACCOUNTING ESTIMATES
•
•
•
•
Communication of need for estimate
Were estimates made by qualified personnel?
Were estimates reviewed and approved?
Have past estimates been inline with actual
results?
• How are estimates in comparison to budgets
and forecasts?
10-12
SUBSTANTIVE TESTS
INTEREST-BEARING LIABILITIES (IBL)
• Agree to BEGINNING BALANCE and CONFIRM with
holders or makers.
• LOAN PROCEEDS
– VOUCH to cash receipts to cash journal and bank statement
– Recalculate Discount/Premium
– Confirm IBL, examine note
• LOAN PAYOFF
–
–
–
–
Recalculate Interest Expense
Recalculate Gain/Loss on Retirement
Vouch to cash disbursements journal and bank statement
Confirm with debt holder if necessary
10-13
INTEREST-BEARING LIABILITIES
• INTEREST PAYMENTS
– Recalculate Interest Expense
• Search for UNRECORDED liabilities
– Inquiry of management
– Bank confirmations
– Unusual amounts of interest expense
– Large receipts of cash during the year
– Payments made after year end
• Ensure DEBT COVENANTS are met.
– Inspect loan agreements.
– Consider GOING CONCERN implications if not met.
– Ensure proper presentation and disclosure.
10-14
Exhibit 10.5
Audit Documentation
10-15
AUDITING STOCKHOLDER'S
EQUITY
• Overview of audit approach
– Large corporations recordkeeping of stock ownership usually done
by a registrar
– Small and closely held corporations may have a stock certificate book
• Review certificate book for stock issued during the year.
• Review record of outstanding stock certificates for stock purchased or retired.
– Transactions must be authorized by the board of directors
or its equivalent
• e.g. an executive committee for an LLC
– Transactions must be consistent with the client's articles of
incorporation.
10-16
AUDITING STOCKHOLDER'S
EQUITY
• PAID-IN CAPITAL
– Agree balances to prior year documentation
– Examine issuances and repurchases of capital stock
• Verify distribution of proceeds between CAPITAL STOCK and
ADDITIONAL PAID-IN CAPITAL
• Trace proceeds to CASH RECEIPTS Journal and bank statement
• If stock is used to acquire assets (e.g. a purchase for stock) trace to PPE.
• Trace payments to CASH DISBURSEMENTS journal and bank
statement
• Determine that all transactions are RECORDED (TRACE from BOD
minutes to the stock accounts and cash journals)
• Verify that all transactions are PROPERLY AUTHORIZED
10-17
AUDITING STOCKHOLDER'S
EQUITY
• RETAINED EARNINGS
– Agree beginning balance with prior year documentation
– Verify the appropriateness of prior-period adjustment
treatment
– Trace net income/loss to INCOME STATEMENT
– Ensure that DIVIDENDS are properly authorized by
BOARD OF DIRECTORS
10-18
Auditing Investments:
Substantive Procedures
• Agree beginning balances to Prior Year documentation
• Review client’s policies and procedures
– Identify individuals authorized to execute trades
with brokers
– Identify individuals who reconcile brokerage
accounts with company records
• Ensure they are independent.
• Purchases of investments
– Vouch to broker’s advice and broker Statement
– Examine board minutes for authorization
10-19
Auditing Investments:
Substantive Procedures (Cont.)
• Sales of investments
– Trace to broker’s advise, cash receipts journal
and bank statement.
– Vouch to authorization from the BOD
• Read minutes for proper execution of transactions
– Recalculate gain or loss on sale
10-20
Auditing Investments:
Substantive Procedures (cont.)
• Determine MARKET VALUE
– Obtain 12/31 market price from Wall Street
Journal, website or other sources
– Evaluate for possible permanent declines in value
• Physically inspect securities held by the client
• Confirm securities held by a broker
– Verify CUSIP Numbers to ensure that there were
no unrecorded sales and subsequent repurchases
– Recorded in company name
10-21
Auditing Investments:
Substantive Procedures (cont.)
• Verify DIVIDEND REVENUE
– Review stocks held by client for dividend
payments (e.g. Moody's, Standard & Poor's,
quote.com).
– If securities held by broker review monthly
statements for dividends.
– Trace dividend received to cash receipts journal
• Evaluate presentation on balance sheet (short-term
vs. long-term asset)
10-22
Trouble Spots in Audits of
Investments
• Valuation of investments
– at cost if market value is not evident
– value impairment that is other than temporary.
• Propriety, effectiveness, and risk disclosure of
derivative securities used as a hedges
• Determination of the fair value of derivatives and
securities, including valuation models and the
reasonableness of key assumptions.
• Determination of significant influence relationship
for equity method investments.
10-23
Derivative Investments, Hedging Activities,
and Investments in Securities (SAS 92)
• Inquiries about the nature of investments and the
reasons for holding them, especially hedging activities.
• Classification affects the accounting treatment of
market values and the unrealized gains and losses on
investments.
• Due to the complexity of Accounting for Derivative
Securities and Hedging Activities, auditors may need
special skills or knowledge to:
– understand client hedging transactions
– ensure that effective controls are in place
– to audit the transactions.
10-24
Auditing Fair Value
• Management’s responsibility to value assets
and liabilities.
• Market-based values preferred
• Three level hierarchy in establishing FMV
when market price is unavailable.
1. Quoted market price for identical assets or liabilities
2. Quoted market price for similar assets or liabilities
3. Estimate using valuation techniques
10-25