1. Electronic Presentations in Microsoft® PowerPoint®
Prepared by
Brad MacDonald
SIAST
© 2003 McGraw-Hill Ryerson Limited
Page references in these notes are taken from the second draft of the text revision

2. Finance and Investment Cycle

3. Learning Objective 1
Describe 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

5. Finance and Investment Cycle
Start Here
Invest excess funds
Financial planning
Finance and Investment Cycle
Mergers and acquisitions
Sell shares or borrow money
Revenue and collection cycle
See exhibit 12-1
Production and payroll cycle
Acquisition cycle
Chapter 12
Copyright © 2003 McGraw-Hill Ryerson Limited 5

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.
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 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.
Pages

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.

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 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
Page

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 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
Pages

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 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.

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 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.
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.
Confirmation
Capital 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
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.
Page 452

22. 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.
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
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.
Page 455

25. 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.
Page

26. 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.
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:
Method
Paper Trail
Amount
Audit Approach
Audit Objective
Control
Test of Controls
Audit 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 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.
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 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
Page 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 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.