chapter 18 auditing investments and cash balances spring 2007 l.
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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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overview of investments
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.

st and lt investments transactions and accounts
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
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
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
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
investments audit objectives


Existence & Occurrence


Rights and Obligations

Presentation and Disclosure

Specific Audit Objective


Cutoff / Timeliness


Cutoff / Timeliness

Valuation at Historical Cost / GAAP

Valuation at Net Realizable Value

Posting and Summarization




Investments Audit Objectives
investments understand internal controls
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
investments understand internal controls10

Stock certificates

Bond certificates

Bond indenture

Broker’s advice

Broker’s statement

F/S of equity investments


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 controls11
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 controls12
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
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 risk14
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
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 tests16
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 tests17
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
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
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
Cash Balance Detection Risk

Inherent risk is normally high due to the susceptibility of cash to misappropriation.

cash balances standard substantive tests
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 tests24
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 tests25
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
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