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Chapter 10 Finance and Investment Cycle 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. 10-2

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. 10-3

Inherent Risks Lease Accounting Loan covenants Related party transactions Complex transactions Impairments 10-4

Investment and Finance Activities Financial Plan Capital budget Raise capital Operate business (all other cycles) Mergers and acquisitions Investment of excess funds 10-5

Control Considerations Transactions authorized by BOARD OF DIRECTORS Documentation: –Investments in securities: BROKER'S ADVICE –Property, plant and equipment: VENDOR'S INVOICE (for purchased PPE) or INTERNAL COST RECORDS (for manufactured PPE) –Bonds and notes payable: Documentation from DEBTHOLDERS –Stockholders' Equity: Documentation from REGISTRAR CASH RECEIPTS/DISBURSEMENTS JOURNALS 10-6

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 or in a secure location –Access to safe-deposit box requires more than one employee –Physical items periodically compared to detail records –Cash receipts from Investing and Financing cycle transactions deposited intact and daily (electronic transfer preferred) 10-7

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 investing and cycle 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 10-8

CONTROL OVER ACCOUNTING ESTIMATES Communication of need for estimate Accumulate data Qualified personnel Review and approval Comparison to results Compare with plans 10-9

SUBSTANTIVE TESTS–INTEREST- BEARING LIABILITIES Agree to BEGINNING BALANCE and CONFIRM with holders or makers. LOAN PROCEEDS –VOUCH to cash receipts –Recalculate Discount/Premium –Confirm IBL, examine note LOAN PAYOFF –Recalculate Interest Expense –Recalculate Gain/Loss on Retirement –Verify cash disbursements 10-10

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 Ensure DEBT COVENANTS are met. –Inspect loan agreements. –Consider GOING CONCERN implications if not met. –Ensure proper presentation and disclosure

AUDITING STOCKHOLDER'S EQUITY Overview of audit approach –EXTERNAL PARTIES involved in record keeping –Transactions must be authorized by the BOARD OF DIRECTORS –Transactions must be consistent with the client's ARTICLES OF INCORPORATION 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 Examine CASH RECEIPTS and CASH DISBURSEMENTS records Determine that all transactions are RECORDED (TRACE from BOD minutes) Verify that all transactions are PROPERLY AUTHORIZED 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 10-12

Auditing Investments: Substantive Procedures Agree beginning balances to Prior Year Documentation Review client’s policies and procedures –Identify those individuals authorized to execute trades with brokers –Identify individuals who reconcile brokerage accounts with company records and ensure they are independent. Purchases of investments –VOUCH to BROKER'S ADVICE (Statement) –Examine BOARD MINUTES for authorization Sales of investments –VOUCH to BROKER'S ADVICE, CASH RECEIPTS RECORDS, and BOARD MINUTES –Recalculate gain or loss on sale –Read minutes for sales of Investments and trace to recording –Trace cash receipts to cash receipts journal and bank statement 10-13

Auditing Investments: Substantive Procedures (cont.) Determine MARKET VALUE –Obtain 12/31 market price from Wall Street Journal or other sources –Evaluate for possible PERMANENT DECLINES PHYSICALLY INSPECT or CONFIRM securities –Verify CUSIP Numbers to ensure that there were no unrecorded sales and subsequent repurchases –Recorded in company name –Can inspect at interim, if safe-deposit box Verify DIVIDEND REVENUE –Review stocks held by client for dividend payments (e.g. Moody's, Standard & Poor's, CNBC.com).CNBC.com –If securities held by broker review monthly statements for dividends. –Trace dividend received to CASH RECEIPTS records Evaluate presentation in BALANCE SHEET (short-term vs. long-term asset) 10-14

Trouble Spots in Audits of Investments Valuation of investments –at cost or market value is not always 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

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

Auditing Fair Value Measurements Management’s responsibility. Market-based values preferred If not available—use assumptions market would have used. If not known—management can use their own assumptions –if no contrary data 10-17