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CHAPTER 18 AUDITING INVESTMENTS AND CASH BALANCES Spring 2007. Overview of Investments. Investing in marketable securities interfaces with 2 other cycles: 1. Dividends and interest received on investments - revenue cycle . 2. Purchases of securities - expenditure cycle .
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CHAPTER 18AUDITING INVESTMENTS AND CASH BALANCESSpring 2007
Overview of Investments Investing in marketable securities interfaces with 2 other cycles: 1. Dividends and interest received on investments - revenue cycle. 2. Purchases of securities - expenditure cycle.
Balance Sheet Trading Securities AFS Securities HTM Securities Cumm. Unrealized holding gains/losses on AFS securities (equity) Equity Investments Income Statement Dividend revenue Interest revenue Realized gains/losses on securities Unrealized gains/losses on trading securities Equity in equity investee’s N/S ST and LT Investments: Transactions and Accounts
Investments General Audit Strategy • Assess Inherent Risk • Use Knowledge of Business and Industry to Perform Analytic Procedures and Assess Analytic Procedures Risk • Assess Control Risk • Evidence of effectiveness gained while obtaining an understanding of internal controls • Evidence of effectiveness of management controls • Evidence of effectiveness from direct tests of programmed controls • Design Appropriate Substantive Tests of Details
Investments Initial Audit Procedures: IR factors • Company policy on risk of investments • Volume of investing transactions generally low • Accounting for investments can become complex • Proper classification of an investment may be contentious (i.e., AFS vs. Trading) • How material are investments? • Short term solvency of entity • Effect of changes in market value (unrealized gain/loss) • Effect of income from investments
Investments Initial Audit Procedures Analytical Procedures • Tremendous variation of investments even within an industry – dependent on what they are invested in • Analytical procedures • current-year and prior-year balances • actual results for the amount of investments and investment income with budgets or other documentation of management’s plans • Return on investment by category compared to other similar investment funds
Assertion Completeness Existence & Occurrence Valuation Rights and Obligations Presentation and Disclosure Specific Audit Objective Completeness Cutoff / Timeliness Validity Cutoff / Timeliness Valuation at Historical Cost / GAAP Valuation at Net Realizable Value Posting and Summarization Ownership Classification Disclosure Investments Audit Objectives
Investments: Understand Internal Controls Control environment • Assignment of authority & responsibility to company officer • Use of appropriate 3rd parties Management Risk Assessment • How management considers fluctuations in market values • Impact of investments on cash flow requirements • Actively manage risks associated with investments in accordance with objectives of board
Documents Stock certificates Bond certificates Bond indenture Broker’s advice Broker’s statement F/S of equity investments Files Investment subsidiary ledger General journal (accrual of bond interest, revenue, market adjustments under FV method, and income earned under equity method) CRJ (record proceeds from sales, receipt of interest and dividends) Voucher and check registers (purchasing and paying for securities) Investments: Understand Internal Controls Information System
Investments: Understand Internal Controls Authorize Investment Transaction • Purchases in accordance w/ mgmt authorization • Sales in accordance w/ mgmt authorization Receive or deliver securities • Securities held by broker or physically secure location • Periodic income subject to cash receipts controls Record transactions • Appropriate supporting documentation and segregation of duties • Mkt adjustments periodically analyzed and adjusted
Investments: Understand Internal Controls Settle transactions • Cash receipts from sales subject to normal cash receipts procedures • Cash disbursements for purchases subject to normal cash disb procedures • Independent reconciliation of brokers advice and stmts with investment subsidiary ledgers Assess investment performance and reporting • Mgmt periodically reviews performance and classification of investments • Periodic BOD review of investments and policies
Investments: Determining Detection Risk • Determine detection risk for each audit objective based on audit risk model after assessing: • Inherent risk • Control risk • Risk that analytic procedures would fail to detect material misstatements. • Need to combine assessments w/ those for cash disb and cash receipts
Investments: Determining Detection Risk When assessing detection risk: • It is difficult to design effective controls for fair value accounting adjustments and • The proper classification of investments often means that low acceptable levels of detection risk for tests of details are usually specified for the valuation or allocation and presentation and disclosure assertions.
Investments: Standard Substantive Tests Initial procedures • Agree beginning balance to prior year workpapers • Review activity in investment-related accounts for entries that are unusual in nature or amount • Test client-prepared schedules of activity (rollforward) in all investments, for mathematical accuracy and agreement with the underlying accounting records. • Determine that schedules and subsidiary investment ledgers agree with related GL control account balances. • These schedules are the basis for add’l substantive tests. Analytical Procedures
Investments: Standard Substantive Tests Test of Details of Transactions • Generally effective when low volume of transactions. • Standard substantive tests in this category are: 1. Inspect and count securities on hand 2. Confirm securities held by others 3. Vouch the individual debits and credits in the various investment accounts (sample basis usually) • Fair value method: Verify year-end market price of securities • Equity method: DR to documentation of investor’s share of the investee’s earnings. CR to documentation of dividends received from investees or worksheets calculating periodic amortization of the excess of cost over underlying book value. 4. Recalculate investment revenue earned
Investments: Standard Substantive Tests Test of Details of Balances: Accounting Estimates When auditing investments, the auditor must apply significant audit judgment with respect to evaluating: • the proper classification of investments and • Trading unrealized gain/loss => I/S • AFS unrealized gain/loss => Equity 2. the fair value of investments.
Auditing Cash Balances Understanding auditing cash balances • Relationship of Cash Balances to Trans. Cycles (fig 18-4) • Revenue cycles increases cash • Expenditure cycle decreases cash • Personnel services cycle decreases cash • Production cycle doesn’t directly affect cash • Financing and investing cycles both increase and decrease cash • Cash balances may not be material, but the volume of transactions through the account almost always is – additionally, higher inherent risk of fraud
Cash Initial Procedures Inherent Risk • High volume of transactions poses risk particularly for existence and completeness. • Nature of cash balances susceptible to theft • Risks pertaining to the rights and obligations, valuation or allocation, and presentation and disclosure minimal due to the absence of complexities involving rights, accounting measurements, estimates, and disclosures. Analytical Procedures • Often can be less helpful except for comparisons of actual to budget
Cash Balance Control Risk Cash receipts and disbursements: Routine transactions => good controls (normally) => assess control risk at a low level.
Cash Balance Detection Risk Inherent risk is normally high due to the susceptibility of cash to misappropriation.
Cash Balances: Standard Substantive Tests Initial procedures • Agree beginning balance to prior year workpapers • Review the G/L for large or unusual transactions. Often this includes the use of GAS Analytical procedures • Consider reliability
Cash Balances: Standard Substantive Tests Tests of Details of Transactions 1. Performing cash cut-off tests 2. Tracing bank transfers Test of Details of Balances 1. counting cash on hand, 2. confirming bank deposit and loan balances, 3. confirming other arrangements with banks, 4. scanning, reviewing, or preparing bank reconciliations, and 5. obtaining and using bank cutoff statements.
Cash Balances: Standard Substantive Tests How to audit bank reconciliations Balance per bank + Deposits in transit - Outstanding checks = Adjusted balance per book Unadjusted balance per book + Bank originated adjustments - Service charges = Adjusted balance per book
Cash Balances: Fraud consideration • Lapping to misappropriate cash receipts • Tests to detect lapping are only performed when control risk for cash receipts transactions is moderate or high. There are 3 procedures that should detect lapping: 1. confirm accounts receivable, 2. make a surprise cash count, and 3. compare details of cash receipts journal entries with the details of corresponding daily deposit slips