3 Learning Objective 1Describe the finance and investment cycle, including typical source documents and controls.
4 Finance and Investment Cycle: Typical Activities Financial planning and raising capital.Interacting with the acquisition and expenditure, production and payroll, and revenue and collection cycles.Entering into mergers, acquisitions, and other investments.Page 437
6 Good Corporate Governance CICA’s Guidance for Directors on Governance Processes for Control identifies the contributions of the board of directors to internal control:approving and monitoring mission, vision, and strategyapproving and monitoring ethical valuesmonitoring management controlevaluating senior managementoverseeing external communicationsassessing the board’s effectivenessBoard level controls are important in the investment cycle.Page
7 Finance and Investment Cycle: Typical Activities Debt and Shareholder Equity Capital:Few transactions, large monetary amounts.Authorization - Cash flow forecast and capital budget, authorizations for sale of stock, debt financing, off balance sheet financing.Custody – Registrar / transfer agent, share certificate book, debt instruments.Recordkeeping – Records of notes and bonds payable, calculated liabilities and credits.Periodic Reconciliation – Reconciliation of outstanding shares.Pages
8 Finance and Investment Cycle: Typical Activities Investments and IntangiblesPurchased assets, accounting allocationsAuthorization - Investments approved by the board of directors or investment committee.Custody – Custodians, physical custody, management responsibility.Recordkeeping – Voucher system, maintenance of accounts.Periodic Reconciliation - Inspect and count negotiable security certificates.Pages
9 Learning Objective 2Give examples of test of controls procedures for obtaining information about the controls over debt and owner equity transactions and investment transactions.
10 Control Risk Assessment Finance and investment transactions are usually individually material, each transaction usually is audited in detail.Reliance on control does not normally reduce the extent of substantive audit work on finance and investment cycle accounts. However, lack of control can lead to significant extended procedures.Pages
11 General Control Considerations Responsibilities lay in the hands of senior management officials.Difficult to have strict segregation of functional responsibilities when senior management officials are involved.A compensating control feature involving two or more persons in each kind of important functional responsibility.Page 444
12 Control over Accounting Estimates Management is responsible for making estimates, and should have a control structure in place.Use of estimates in accounting is common.Test of controls amounts to enquiry as to controls in place for estimation.Substantive procedures will include recalculation, and comparison of auditor’s estimate to management’s estimate.Pages
13 Control over Accounting Estimates Control structure for estimates should include:management communication of need for proper estimatesaccumulation of relevant, sufficient, and reliable data.preparation of estimates by qualified personneladequate review and approval by appropriate authoritycomparison with prior estimates to assess reliabilityconsideration by management of whether estimates are consistent with operational plansPage
14 Control Risk Assessment for Notes Payable Some companies may have numerous debt financing transactions, warranting a more detailed approach to testing of controls.An internal control questionnaire is presented in Appendix 12A to illustrate typical questions for the control objectives.Page 445
15 Control Risk Assessment for Derivatives Key controls for derivatives:monitoring by independent control staffderivatives personnel to obtain senior management approval prior to exceeding limitssenior management to address limit excessesaccurate transmittal of derivatives positionsperformance of appropriate reconciliationstraders and management to define constraints, monitor activities,and justify excessesregular review of controls and resultsreview of limits and risk tolerancePages
16 Control Risk Assessment Auditors will often audit 100% of investment and finance cycle transactions.Few transactions make it efficient to give complete coverage.Control deficiencies are still important to the audit.Complicated financial instruments call for procedures to detect errors, irregularities, and frauds.Pages
17 Learning Objective 3Describe some common errors, irregularities, and frauds in the accounting for capital transactions and investments, and design some audit and investigation procedures for detecting them.
18 Owners’ Equity Typical assertions for owners equity: The number of shares shown as issued is in fact issued.No other shares have been issued and are not recordedThe accounting is proper for options, warrants, and other stock plans, and related disclosures are adequate.The valuation of shares issued for non-cash consideration is proper. All owners’ equity transactions have been authorized by the board of directors.Page 449
19 Owners’ Equity Documentation Confirmation Owners’ equity transactions are well documented (e.g., board of directors’ minutes, proxy statements), and transactions can be vouched to these documents.ConfirmationCapital stock may be confirmed when independent registrars and transfer agents are employed or vouched to share record documents.Page 449
20 Long-term Liabilities Typical assertions for long-term liabilities:All liabilities are recorded.Liabilities are properly classified.New liabilities are properly authorized.Terms, conditions, and restrictions are disclosed.Disclosures of maturities and lease obligations are adequate.All important contingencies are accrued or disclosed.Page
21 Long-term Liabilities ConfirmationAuditors usually obtain independent written confirmation.Confirmations are sent to lenders used in past even if there is no recorded liability.Off-Balance Sheet FinancingDifficult to define commitments and contingencies.Footnote disclosure should be considered.Page 452
22 Long-term Liabilities Analytical proceduresInterest expense is related to interest-bearing liabilities.Recalculation and comparisonDeferred Credits – Calculated BalancesDeferred profit on installment sales, future income taxes, deferred contract revenue.All of these items are suitable for recalculation.Pages
23 Investments and Intangibles Companies can have a wide variety of investments and intangibles.Management assertions will depend on the nature of the investments or intangibles possessed.Generally, accounts consist of a few large transactions.Page 454
24 Investments and Intangibles ConfirmationLimited to confirmation of securities held by trustees or brokers.EnquiryCompany counsel can be queried about issues relating to intangibles.Income from intangiblesRoyalty income can be confirmed or vouched to licencee’s reports and payments.Page 455
25 Investments and Intangibles InspectionInvestment property can be inspected.Official documents for patents, copyrights and trademarks can be inspected.Document VouchingInvestments can be vouched to broker statements.Market valuations may be required in some cases.Vouching may be extensive for R&D.Page
26 Investments and Intangibles External documentationAuditors can use quoted market values, dividend reports, and financial statements of investments.Equity Method InvestmentsAuditor should obtain audited financial statements from equity investments.Amortization RecalculationRecalculation provides sufficient evidence.Page 456
27 Audit Casettes: Substantive Procedures Specific examples of test of controls and substantive procedures are in the form of casettes (mini-case studies).Each casette has the following parts:MethodPaper TrailAmountAudit ApproachAudit ObjectiveControlTest of ControlsAudit of Balance
28 Audit Casettes 12.1 Unregistered Sale of Securities: A.T. Bliss & Company sold investment contracts in the form of limited partnership interests to the public. These securities sales should have been under a public registration filing, but they were not.12.2 Tax Loss Carry-forwards:Aetna had losses in taxable income operations. Confident that future taxable income would absorb the loss, the company booked and reported a tax benefit for the loss carry-forward.Pages
29 Audit Casettes 12.3 Off-Balance Sheet Inventory Financing Verity Distillery Company used the “product repurchase” ploy to convert its inventory to cash, failing to disclose the obligation to repurchase it later. Related party transactions were not disclosed.12.4 A Consolidation by Any Other NameDigilog, Inc., formed another company named DBS International (DBSI), controlled it, and did not consolidate its financial position and results of operations in the Digilog financial statements. Digilog income was overstated, and assets and liabilities were understated.Pages 453 – 454,
30 Other Aspects of Clever Accounting and Fraud Top management personnel who deal with the transactions involved in investments, long-term debt, and shareholders’ equity are not subject to the same kind of control as lower-level employees.Generally, top management is able to override detail procedural controls.Page 458
31 Long-term Liabilities and Owners’ Equity Fictitious liabilities may be created to misdirect cash into the hands of an officer.Also consider fraud against outsiders:Material misrepresentations or omissions in the financial statements.Income tax evasion and fraud should be considered.Concealment of default of loan covenants.Page
32 Other Aspects of Clever Accounting and Fraud Intent to commit fraud is difficult to prove:Audit should be performed with professional skepticism, meaning the auditor should beaware of factors that increase risk of misstatementsensitized to contradictory evidence and assumptions of management’s good faithRed flags = Higher inherent risk which leads to increasing the level of substantive proceduresPage 460
33 Other Aspects of Clever Accounting and Fraud Generally, the auditor is less likely to detect fraud because of the deliberate concealment involved.Once fraud or violation of securities regulation is uncovered, the auditor should seek legal counsel.Page 460
34 Investments and Intangibles Theft, diversion, and unauthorized use of investment securities should be considered.Theft is possible where custody controls are weak.Diversions occur when securities are used as collateral during the year, and returned for year-end counts.Cash payments from investments may not fit the cash control system due to size and unusual nature of the payments.Pages
35 Appendix 12AInternal control questionnaires for notes payable and substantive audit programs for owners’ equity, notes payable, and long-term debt and investments, intangibles, and related accounts are illustrated.