1. Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Auditing & Assurance Services, 6e

2. 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

3. 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

4. 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

5. Inherent Risks Lease Accounting Loan covenants Related-party transactions Complex transactions Impairments 10-5

6. Exhibit 10.1 Finance and Investment Shenanigans 10-6

7. Investment and Finance Activities Financial Plan Capital budget Raise capital Operate business (all other cycles) Mergers and acquisitions Investment of excess funds 10-7

8. Exhibit 10.3 Finance and Investment Cycle 10-8

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. Exhibit 10.5 Audit Documentation 10-15

16. AUDITING STOCKHOLDER'S EQUITY Overview of audit approach –Large corporations r ecordkeeping 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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