What are the textbook-version (perfect world) internal controls used in the investment cycle?
Separation of duties
Purchase or Sale: requires high-level authorization, preferably the Board of Directors
Custody: preferably a third-party, or at a minimum by two separate company officials with the investments stored in a safe-deposit box
Record Keeping: a separate party from anyone mentioned above should keep records
Which three assertions are most important when auditing the investment balance?
Existence (do they exist)
Completeness (are all of them included)
Valuation and Allocation (what are they worth)
When auditing investment balances, how does the auditor verify the completeness assertion?
Perform cut-off procedures
Search minutes and other records for approved derivatives
Confirm securities held by a 3rd party
Perform a physical count of investments held by the entity
Verify actual interest earned vs interest expectation. A difference could indicate the instance of an interest rate swap.
What is the most difficult challenge when attempting to verify the completeness with regard to derivatives?
There is no initial investment recorded in the journal or FS. Any financial transaction occurs at the completion of the contract when it is executed. It may be difficult for the auditor to find the commitment to the derivative.
When auditing investment balances, how does the auditor verify the valuation and allocation assertion?
Foot a listing of investments by category and compare to general ledger
Review activity for additions, sales, executions
Compare assigned values vs market prices on the balance sheet date
When auditing investment balances, how does the auditor verify the existence assertion?
Examination of securities on hand (should coincide with exam of other liquid assets)
Verify actual vs expected interest earned
When auditing investment transactions, how does the auditor verify the completeness, existence and occurrence assertions?
Completeness: Analytical procedures testing reasonableness regarding dividend and interest transactions
Calculations to validate recorded gains/losses from security sales
When auditing investment transactions, how does the auditor verify the understandability and classification assertions?
Ensure the investments are recorded in the proper account and that the gains and losses are appropriately recorded, especially if sold.
Obtain written representation from management regarding the holding vs selling intent to verify trading, available-for-sale, or held-to-maturity status.
What value should be assigned for marketable trading, available-for-sale, or held-to-maturity securities? Which accounts are affected?
Trading: balance should be the fair value, with unrealized G/L posted in the income statement.
Available-for-Sale: balance should be fair value, with unrealized G/L posted to other comprehensive income.
Held-to-Maturity: balance should be amortized cost, no G/L adjustment is made.
Which criteria must be met for an entity to account for a derivative as a hedge?
It must be designated a hedge at its inception
Management must document the hedging relationship (what they are hedging and why), risk management objective, and strategy for undertaking the hedge
Management must expect the hedge to be effective and periodically test this effectiveness
What types of considerations should be made to verify if the cash-flow hedge will probably occur?
The frequency of similar past transactions
The ability of the entity to carry out the transaction
The extent of loss that could result if the transaction does not occur
The likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose
What value should be assigned to a hedge derivative?
What evidence should be obtained to validate equity-type investments?
A written representation from management regarding the entity’s ability to exercise significant influence over the investment (if significant influence, the investment should be consolidated, not treated as an equity investment)
Read the audited FS and audit report of the investee. If audited statements aren’t available, request that they get the FS audited.
Investigate and obtain evidence of items that are materially different than those reported by the client.
When determining fair value, what concept is used to determine the price?
Pretend you were going to sell the investment on the date of the balance sheet. How much money would you obtain if you were to sell it to a 3rd party in an arms-length deal.
What are the three levels of evidence used to value marketable securities and derivatives?
Level 1: observable quoted prices in active markets for identical assets or liabilities
Level 2: Observable inputs other than quoted market prices for identical assets or liabilities
** quoted price for an identical item, but NOT in an active market OR
** quote price in an active market but not for an identical item
Level 3: UNobservable inputs using estimates and valuation methods, such as discounted cash flow, based on management’s judgment (must be included in the disclosures)
True / False: It is the auditor's job to ascertain a fair value amount for each investment.
It's management's job to determine the fair value amount. It's the auditor's job to determine if the amount is reasonable.
True / False: Because investments are not only current, but will affect the future income and risk for the entity, the auditor should use the current evidence to project the future impact.
The auditor is only responsible to evaluate information available at the time of the audit, and is not responsible for predicting future conditions that, if known at the time of the audit, might have affected fair value measurements and disclosures.
What conditions might indicate the need to account for an impairment loss on an investment?
Fair value is significantly below cost that has existed for an extended period or for a reason not likely to improve (such as the deterioration of the financial condition of the issuer)
The security has been downgraded by a rating agency
Dividends or interest payments have been reduced or eliminated