1. CHAPTER 18 AUDITING INVESTMENTS AND CASH BALANCES Spring 2007

2. 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.

3. ST and LT Investments: Transactions and Accounts
Income Statement
Dividend revenue
Interest revenue
Realized gains/losses on securities
Unrealized gains/losses on trading securities
Equity in equity investee’s N/S
Balance Sheet
Trading Securities
AFS Securities
HTM Securities
Cumm. Unrealized holding gains/losses on AFS securities (equity)
Equity Investments

4. 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
Recall that within this general strategy, the relative emphasis placed on the different types of tests can change.
Low IR, emphasis on AP
Emphasis on CR --
Emphasis on Substantive tests
This is the same for all cycles!!!!!!

5. 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

6. 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

8. Investments Audit Objectives
Assertion
Completeness
Existence & Occurrence
Valuation
Rights and Obligations
Presentation and Disclosure
Specific Audit Objective
Completeness
Cutoff / Timeliness
Validity
Valuation at Historical Cost / GAAP
Valuation at Net Realizable Value
Posting and Summarization
Ownership
Classification
Disclosure

9. 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

10. Investments: Understand Internal Controls
Information System
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)

11. 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

12. 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

13. 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

14. 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.

15. 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
Rollforward:
Beg Bal + purchases – sales + other adjustments = Ending Bal
Test each piece of it to get comfort.

16. 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

17. 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.

18. 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

19. Cash Audit Objectives

20. 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

21. Cash Balance Control Risk
Cash receipts and disbursements:
Routine transactions => good controls (normally) => assess control risk at a low level.

22. Cash Balance Detection Risk
Inherent risk is normally high due to the susceptibility of cash to misappropriation.

23. 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

24. 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.

25. 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

26. 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
Cash theft covered up by applying AR collections to unrelated accounts. Cash accountant should not also be AR accountant.