Audit of the Financing and Investing Cycle: Test of Controls and Substantive Tests of Transactions

Nature▪ Include the responsibilities of planning the

cash needs, raising capital, and investing funds

▪ These cycles embrace the major non-operating activities of many companies

▪ Every business must raise money to finance the acquisition of productive assets used to produce revenue

Financing Cycle Transactions

▪ Borrowing from others excluding open trade accounts with creditors.

▪ Share capital and dividend transactions share issuance and reacquisition, shares returned and dividend declarations are the principal transactions involving shareholder’s equity

Investing Cycle Transactions

▪Acquisitions and disposals of financial assets.▪Lending to others, excluding open trade accounts with customers.

Accounts typically affected by the financing and investing cycles:

▪ Notes payable – non trade (short term and long term)

▪ Bonds payable

▪ Mortgage payable

▪ Long-term liability under capital lease

▪ Share capital

▪ Investment in securities (temporary and long term)

▪ Non-trade accounts receivable

▪ Property, plant and equipment

▪ Accumulated depreciation

▪ Intangibles and other assets

▪ Cash in bank

▪ Interest expense

▪ Accrued interest payable

▪ Paid-in capital in excess of par

▪ Donated capital

▪ Retained earnings

▪ Appropriation of retained earnings

▪ Treasury shares

▪ Dividends declared

▪ Proprietorship – capital account

▪ Partnership – capital account

Documents and Records

▪ Share certificate – an engraved form showing the number of shares owned by a shareholder in a corporation

▪ Bond certificate – an engraved form showing the number of bonds owned by a bondholder

▪ Bond indenture – a contract stating the terms of the bond issue between the bondholder and the issuing entity

▪ Broker’s advice – a statement from a broker specifying the details of an investing transaction

Auditing the Financing Cycle

Possible errors related to financing activities include:

▪ Failing to make interest accruals, or making them twice

▪ Accruing interest in the wrong period

▪ Making incorrect estimates of allowances for obligations

▪ Failing to recognize that the entity violated a debt agreement

▪ Failing to record dividends that were declared

Internal Control Over Financing Cycle Transactions

▪ existence or occurrence/ rights and obligations

1. Issuance of long-term notes, bonds , and share capitals are made in accordance with board of directors’ authorizations and legal requirements and proceeds are promptly deposited intact

2. Payments of bond interest and cash dividends are made to proper payees in accordance with the board of directors or management authorizations

3. Redemption and reacquisition of bonds and share capital transactions are executed in accordance with board of directors’ authorizations

4. Cancellation of notes when they are paid to avoid double payment

5. Recorded balances are periodically verified with bondholders and shareholders

Valuation / Completeness / Classification

▪Transactions and events are correctly recorded as to amount, classification, and accounting period

▪Transactions are promptly and correctly posted to individual accounts

Evaluation of Internal Control over Financial Cycle Transactions

1. Current liabilities

▪ A system authorization on both as to original transaction resulting in a liability and as to payment of the liability should be well-defined and established

▪ Satisfactory system of record keeping with adequate forms and documentation should be instituted

▪ There should be a plan of organization

Long-term liabilities

▪ Should be properly authorized

▪ There should be proper control over issued and unissued obligations

▪ Redeemed bonds should be cancelled, properly mutilated and retained

▪ Bond ledger should be used in which details of bonds issued, cancelled and outstanding are shown

▪ Proper control should be exercised over the payment of interest on long-term liabilities

Share Capital

▪ Internal control measures and proper accounting

▪ Share certificates should be serially numbered and the authority for signing and issuing the certificates be designated by the board of directors

▪ Corresponding records of certificates should be prepared

▪ Cancelled certificates should be mutilated and any necessary documentary stamps should be attached

▪ Entries for share issuances and transfers should be made by a person who does not have authority to sign and issue certificated

Auditing the Investing Cycle

▪ Basic considerations:

Audit risk for investing cycle transactions and balances can generally be kept at a very low level in most enterprises since:

1.These transactions occur infrequently

2.Effectivity controls can be maintained at relatively little cost

Internal Control Over Investing Cycle Transactions

▪ Three operating objectives of internal control applicable to the investing cycle are:

1.Executing of transactions

2.Recording of transactions

3.Custody of assets

Existence or Occurrence / Rights and Obligations

▪ Purchases of property and equipment, securities and intangibles are made in accordance with management’s authorization

▪ Sales of property and equipment, securities and intangibles should be authorized

▪ Dividend and interest checks from investments are promptly deposited intact

▪ Access to property and equipment, securities and intangibles are restricted to authorized personnel

▪ Recorded balances are composed with existing assets at reasonable intervals

Valuation / Completeness / Classification

▪Transactions and events are correctly recorded as to amount, classification and accounting period

▪Transactions are promptly and correctly posted to individual investment accounts

Evaluation of Internal Control Over Investing Cycle Transactions

1. Internal control over investments

▪ Purchases and sales should be made only on proper authorization

▪ Access to securities should not be vested on one person only

▪ Custodianship and accounting for securities should be separated

▪ Securities must be physically controlled

▪ Revenues received from the investments periodically should be reconciled with the amounts that should be received

2. Internal control over fixed assets

▪ Proper authorization

▪ Clearly defined and sound policy for differentiation of capital and revenue expenditures should be established

▪ Fixed assets controlling account should be conducted and supported by detailed plant records

▪ Physical inspections of fixed assets

▪ Periodic review of adequacy of insurance

▪ Reasonable depreciation policy and must be consistently applied

3. Internal control over intangible assets

▪ Proper authorization

▪ Adequacy and consistency of accounting policies governing intangible assets should be reviewed periodically

▪ General ledger account should be supported by adequate detailed records and should be periodically reconciled

▪ Schedules of intangibles should be prepared periodically and be reviewed by a responsible official

Test of Controls and Substantive Tests of Transactions: Investing Cycle

1. Trace transactions for purchases and sales of property and equipment, securities and intangibles through the system

2. Review reports by internal auditors on their periodic inspections to property and equipment, securities and intangibles

3. Review monthly reports by officer of client company on securities owned, purchased and sold, and revenue earned

4. Review significant changes in the composition of property and equipment and related liens and mortgages