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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

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Presentation Outline

I. Overview of Finance and Investing Cycle

II. Audit of Liabilities and Stockholders’ Equity

III. Audit of Investments

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I. Overview of Finance and Investing Cycle

A. Investing and Financing Cycle Activities

B. Inherent Risks

C. Investment and Finance Activities

D. Control Considerations

E. Finance and Investment Cycle: Control Procedures

F. Control Over Accounting Estimates

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A. Investing and Financing Cycle Activities

• 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; property, plant and equipment; notes and bonds payable; and, stockholders' equity accounts.

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B. Inherent Risks

• Lease Accounting – circumventing capital lease rules to remove debt from balance sheet.

• Loan covenants – intentional misstatement to avoid having banks call loans.

• Related party transactions – more risk because they are not at arms-length.

• Complex transactions – transactions are often structured to get around GAAP. Makes them

difficult and hard to audit.• Impairments – taking a big bath in bad years

for investments to create reserves to reduce expenses in the future.

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C. Investment and Finance Activities

• Financial Planning – cash flow planning and capital budgeting serve as controls.

• Raise capital – signature approval of high-ranking officers and consent of board of directors. Registrars and transfer

agents (p. 364)• Operate business (all other cycles) – all cycles interact with

finance and investment cycle.• Mergers and acquisitions – involve sources and uses of

funds.• Invest excess funds – earning a short-term return on excess

cash.

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D. 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

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10-9E. Finance and Investment Cycle:

Control Procedures• Physical Controls

– Securities numbered and in the client's name– Securities held by an independent custodian or in a secure location– Access to safe-deposit box requires the presence of more than one

employee– Physical items periodically compared to detail records– Cash receipts from Investing and Financing cycle transactions

deposited intact and daily• Segregation of Duties

– Transactions AUTHORIZED by the Board of Directors– General Accounting RECORDS transactions – A separate function or external custodian has CUSTODY

• 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.

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10-10F. Control Over Accounting Estimates

• Management emphasis on proper estimation• Accumulation of sufficient relevant data from reliable

sources• Qualified personnel prepare estimates• Review and approval at appropriate levels of authority• Comparison of prior estimates to results to evaluate

reliability of estimate approach.• Determine if estimates are consistent with current

company plans and operations.

A sample of accounting estimates are provided on the top of p. 368. Specific aspects of estimate

development an auditor considers include:

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II. Audit of Liabilities and Stockholders’ Equity

A. Substantive Testing for Interest-Bearing Liabilities

B. Audit Documentation – Exhibit 10.4

C. General Audit Concerns for Stockholders’ Equity

D. Auditing Paid-in Capital

E. Auditing Retained Earnings

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A. Substantive Testing for Interest-Bearing Liabilities

• Agree to BEGINNING BALANCE and CONFIRM with holders or makers.

• LOAN PROCEEDS– VOUCH to cash receipts– Recalculate Discount/Premium– Examine note for interest, payment terms, collateral, debt

covenants, etc.• LOAN PAYOFF

– Recalculate Interest Expense– Recalculate Gain/Loss on Retirement– Verify cash disbursements

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• 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.

A. Substantive Testing for Interest-Bearing Liabilities (Continued)

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B. Audit Documentation – Exhibit 10.4 p. 371

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C. General Audit Concerns for Stockholders’ Equity

• Overview of audit approach– EXTERNAL PARTIES involved in record keeping can

confirm stockholders’ equity. Otherwise, items can be vouched to the certificate book stubs.

– Transactions must be authorized by the BOARD OF DIRECTORS

– Transactions must be consistent with the client's ARTICLES OF INCORPORATION

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D. Auditing 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

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E. Auditing 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

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III. Audit of Investments

A. Substantive Audit Procedures for Investments

B. Trouble Spots in the Audit of Investments

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A. Substantive Audit Procedures for Investments

• Agree balances to Prior Year Documentation• 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

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A. Substantive Audit Procedures for Investments (Continued)

• Determine MARKET VALUE (SFAS 115)– Obtain 12/31 market price from Wall Street Journal or other sources– Evaluate for possible PERMANENT DECLINES

• PHYSICALLY INSPECT or CONFIRM securities Verify Certificate Numbers to ensure that there were no unrecorded sales and subsequent repurchases – Made in company name – Can inspect at interim, if safe-deposit box

• Verify DIVIDEND REVENUE– Examine CASH RECEIPTS records– Compare to external sources (Moody's, Standard & Poor's)

• Evaluate presentation in BALANCE SHEET (short-term vs. long-term asset)

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10-21B. Trouble Spots in the Audit of

Investments

• Valuation of investments at cost, market, or 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.

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Summary

• Accounts involving Investments, Property-Plant and Equipment, Debt, and Equity

• Inherent risk for leases, loan covenants, related parties, complex transactions, and big baths

• Estimate process and evaluation• Audit of liabilities and stockholders’ equity

• Value of investments and amount of investment income