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Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Brad MacDonald SIAST © 2003 McGraw-Hill Ryerson Limited
Copyright © 2003 McGraw-Hill Ryerson Limited Chapte r Finance and Investment Cycle
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 12 3 Learning Objective 1 Describe the finance and investment cycle, including typical source documents and controls.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 12 4 Finance and Investment Cycle: Typical Activities n Financial planning and raising capital. n Interacting with the acquisition and expenditure, production and payroll, and revenue and collection cycles. n Entering into mergers, acquisitions, and other investments.
Finance and Investment Cycle Start Here Financial planning Production and payroll cycle Mergers and acquisitions Acquisition cycle Sell shares or borrow money Revenue and collection cycle Invest excess funds Copyright © 2003 McGraw-Hill Ryerson Limited 5 Chapter 12
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 12 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 strategy –approving and monitoring ethical values –monitoring management control –evaluating senior management –overseeing external communications –assessing the board’s effectiveness Board level controls are important in the investment cycle.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 12 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 12 8 Finance and Investment Cycle: Typical Activities Investments and Intangibles Purchased assets, accounting allocations –Authorization - 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 12 9 Learning Objective 2 Give examples of test of controls procedures for obtaining information about the controls over debt and owner equity transactions and investment transactions.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Control over Accounting Estimates Control structure for estimates should include: –management communication of need for proper estimates –accumulation of relevant, sufficient, and reliable data. –preparation of estimates by qualified personnel –adequate review and approval by appropriate authority –comparison with prior estimates to assess reliability –consideration by management of whether estimates are consistent with operational plans
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Control Risk Assessment for Derivatives Key controls for derivatives: –monitoring by independent control staff –derivatives personnel to obtain senior management approval prior to exceeding limits –senior management to address limit excesses –accurate transmittal of derivatives positions –performance of appropriate reconciliations –traders and management to define constraints, monitor activities,and justify excesses –regular review of controls and results –review of limits and risk tolerance
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Learning Objective 3 Describe some common errors, irregularities, and frauds in the accounting for capital transactions and investments, and design some audit and investigation procedures for detecting them.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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 recorded –The 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Owners’ Equity Documentation –Owners’ equity transactions are well documented (e.g., board of directors’ minutes, proxy statements), and transactions can be vouched to these documents. Confirmation –Capital stock may be confirmed when independent registrars and transfer agents are employed or vouched to share record documents.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Long-term Liabilities Confirmation –Auditors usually obtain independent written confirmation. –Confirmations are sent to lenders used in past even if there is no recorded liability. Off-Balance Sheet Financing –Difficult to define commitments and contingencies. –Footnote disclosure should be considered.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Long-term Liabilities Analytical procedures –Interest expense is related to interest-bearing liabilities. Recalculation and comparison Deferred Credits – Calculated Balances –Deferred profit on installment sales, future income taxes, deferred contract revenue. –All of these items are suitable for recalculation.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Investments and Intangibles Confirmation –Limited to confirmation of securities held by trustees or brokers. Enquiry –Company counsel can be queried about issues relating to intangibles. Income from intangibles –Royalty income can be confirmed or vouched to licencee’s reports and payments.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Investments and Intangibles Inspection –Investment property can be inspected. –Official documents for patents, copyrights and trademarks can be inspected. Document Vouching –Investments can be vouched to broker statements. –Market valuations may be required in some cases. –Vouching may be extensive for R&D.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Investments and Intangibles External documentation –Auditors can use quoted market values, dividend reports, and financial statements of investments. Equity Method Investments –Auditor should obtain audited financial statements from equity investments. Amortization Recalculation –Recalculation provides sufficient evidence.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Specific examples of test of controls and substantive procedures are in the form of casettes (mini-case studies). –Each casette has the following parts: Audit Casettes: Substantive Procedures Method Paper Trail Amount Audit ObjectiveControl Test of Controls Audit of Balance Audit Approach
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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 A Consolidation by Any Other Name –Digilog, 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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 be aware of factors that increase risk of misstatement sensitized to contradictory evidence and assumptions of management’s good faith –Red flags = Higher inherent risk which leads to increasing the level of substantive procedures
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 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.
Copyright © 2003 McGraw-Hill Ryerson Limited Chapter Appendix 12A Internal 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.
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