Chapter 16

What are the main transaction-related assertions for investments?

The main transaction-related assertions for investments are 1. occurrence, 2. authorization, 3. completeness, 4. accuracy, and 5. classification.

What information is examined on the canceled or substitute checks returned with the cutoff bank statement?

The outstanding checks or substitute checks returned with the cutoff bank statement are examined for proper payee, amount, and endorsement.

Fair value.

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Confirmation.

The process of obtaining and evaluating direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions.

Explain why the standard bank confirmation form does *not* identify all information about an entity's bank accounts or loans.

The standard bank confirmation form does not identify all information about an entity's bank deposits or loans because *it does not require bank personnel to conduct a comprehensive, detailed search of the bank's records* beyond the account information requested on the confirmation.

What two presentation classification issues are important for the audit of investments?

The two presentation classification issues that are important for the audit of investments are: 1) Marketable securities need to be properly classified between held-to-maturity, trading, and available-for-sale. 2) The financial statement classification requires that all trading securities be reported as current assets and held-to-maturity securities and individual available-for-sale securities be classified as current or noncurrent assets based on whether management expects to convert them to cash within the next twelve months.

Extended bank reconciliation procedures

These procedures include examining the disposition of the reconciling items included in the prior months' reconciliations and the reconciling items included in the current bank reconciliation.

List three fraud-related audit procedures for cash.

Three fraud-related audit procedures for cash are: 1) *Extended bank reconciliation procedures*. 2) *Proof of cash*. 3) *Tests for kiting*.

*WORD PROBLEM* Sevcik Company's auditor received, directly from the banks, confirmations and cutoff statements with related checks and deposit tickets for Sevcik's three general-purpose bank accounts. The auditor determined that the controls over cash are satisfactory and can be relied upon. The proper cutoff of external cash receipts and disbursements was established. No bank accounts were opened or closed during the year. -Prepare the audit program of substantive procedures to verify Sevcik's bank balances. Ignore any other cash accounts

Typical audit program steps for auditing Sevcik's bank balance include the following steps: 1) Review answers to questions on confirmation requests to determine proper recognition in accounting records and the necessity for financial statement disclosure. 2) Make inquiries as to compensating balances and restrictions. 3) Obtain copies of the bank reconciliations as of the balance sheet date and 4) Trace the adjusted book balances to the general ledger balances; and 5) Compare the bank balances to the opening balances on the cutoff bank statements. 6) Compare the bank balances to the balances on the confirmations. 7) Trace amounts of deposits in transit to the cutoff bank statements and ascertain whether the time lags are reasonable. 8) Verify the clerical accuracy of the reconciliations. 9) Obtain explanation for unusual reconciling items, including checks drawn to "bearer," "cash," and related parties. 10) Trace checks dated prior to the end of the period that were returned with the cutoff statements to the list of outstanding checks. 11) Investigate outstanding checks that did not clear with the cutoff bank statements. 12) Examine a sample of checks for payee, amount, date, authorized signatures, and endorsements to determine any deviations from company policy or fraud in the accounting records. 13) Prepare a bank transfer schedule from a review of the cash receipts and disbursements journals, bank statements, and related paid checks for the last few days before and the first few days after year-end. Review the schedule to determine that the deposit and disbursement of each transfer is recorded in the proper period. 14) Trace incomplete transfers to the schedule of outstanding checks and deposits in transit.

Select the most appropriate procedure from the following list and enter the number in the appropriate place on the grid. (An audit procedure may be selected once or not at all.) Audit Procedure: Verify that transfers from the current to the noncurrent investment portfolio have been properly recorded.

Verify that investments are properly described and classified in the financial statements (presentation and disclosure-classification).

Select the most appropriate procedure from the following list and enter the number in the appropriate place on the grid. (An audit procedure may be selected once or not at all.) Audit Procedure: Determine that any impairments in the price of investments have been properly recorded.

Verify that investments are properly valued at the lower of cost or market at the balance sheet date (valuation and allocation).

Select the most appropriate procedure from the following list and enter the number in the appropriate place on the grid. (An audit procedure may be selected once or not at all.) Audit Procedure: Obtain positive confirmations as of the balance sheet date of investments held by independent custodians.

Verify that recorded investments represent investments actually owned at the balance sheet date (rights and obligations).

The primary evidence regarding *year-end bank balances* is documented in the a. Standard bank confirmations. b. Outstanding check listing. c. Interbank transfer schedule. d. Bank deposit lead schedule.

a. Standard bank confirmations.

On receiving the *cutoff bank statement*, the auditor should vouch a. Deposits in transit on the year-end bank reconciliation to deposits in the cash receipts journal. b. Checks dated before year-end listed as outstanding on the year-end bank reconciliation to the cutoff statement. c. Deposits listed on the cutoff statement to deposits in the cash receipts journal. d. Checks dated after year-end to outstanding checks listed on the year-end bank reconciliation and to the cutoff statement.

b. Checks dated before year-end listed as outstanding on the year-end bank reconciliation to the cutoff statement.

An auditor testing *long-term investments* would ordinarily use substantive analytical procedures to ascertain the *reasonableness* of the a. Existence of unrealized gains or losses in the portfolio. b. Completeness of recorded investment income. c. Classification between current and noncurrent portfolios. d. Valuation of marketable equity securities.

b. Completeness of recorded investment income.

To establish the *existence and rights of a long-term investment* in the common stock of a publicly traded company, an auditor ordinarily performs a security count or a. Relies on the entity's internal controls if the auditor has reasonable assurance that the control activities are being applied as prescribed. b. Confirms the number of shares owned that are held by an independent custodian. c. Determines the market price per share at the balance sheet date from published quotations. d. Confirms the number of shares owned with the issuing company.

b. Confirms the number of shares owned that are held by an independent custodian.

Which of the following is likely to be the most effective audit procedure for *verifying dividends earned on investments* in publicly traded equity securities? a. Trace deposits of dividend checks to the cash receipts book. b. Reconcile recorded earnings with the dividend earnings reported in the investment broker statement. c. Compare the amounts received with prior-year dividends received. d. Recompute selected extensions and footings of dividend schedules and compare totals to the general ledger.

b. Reconcile recorded earnings with the dividend earnings reported in the investment broker statement.

The audit firm's valuation specialist would likely be brought in to assist in the audit of *fair value measurements* at an entity when the following is present: a. The entity is a new audit client. b. Significant uncertainty exists in key inputs to the entity's valuation models. c. The entity has a financial instrument with a Level 2 input. d. The entity owns a large and diverse portfolio of publicly traded stock.

b. Significant uncertainty exists in key inputs to the entity's valuation models.

An auditor would most likely verify the *interest earned on bond investments* by a. Vouching the receipt and deposit of interest checks. b. Confirming the bond interest rate with the issuer of the bonds. c. Recomputing the interest earned on the basis of face amount, interest rate, and period held. d. Testing the controls over cash receipts.

c. Recomputing the interest earned on the basis of face amount, interest rate, and period held.

An auditor ordinarily sends a standard confirmation request to all banks with which the entity has done business during the year under audit, *regardless of the year-end balance*. One purpose of this procedure is to a. Provide the data necessary to prepare a proof of cash. b. Request that a cutoff bank statement and related checks be sent to the auditor. c. Detect kiting activities that may otherwise not be discovered. d. Seek information about loans from the banks.

d. Seek information about loans from the banks.

Which of the following controls would most effectively ensure that the *proper custody of assets in the investing process* is maintained? a. Direct access to securities in the safe-deposit box is limited to one corporate officer. b. Personnel who post investment transactions to the general ledger are not permitted to update the investment subsidiary ledger. c. Purchase and sale of investments are executed on the specific authorization of the board of directors. d. The recorded balances in the investment subsidiary ledger are periodically compared with the contents of the safe-deposit box by independent personnel.

d. The recorded balances in the investment subsidiary ledger are periodically compared with the contents of the safe-deposit box by independent personnel.

Briefly describe each type of bank account.

-A *general cash account* is the principal cash account for most entities. The major source of cash receipts for this account is the revenue process, and the major sources of cash disbursements are the purchasing and human resource management processes. -Companies that have multiple locations are likely to have *branch accounts*. Such accounts provide the branch with the ability to pay local expenses and to maintain banking relations with the local community.

What are the affects of a major internal control activity that directly affects the audit of cash?

-A major internal control activity that directly affects the audit of cash is the completion of a monthly bank reconciliation by entity personnel who are independent of the handling and recording of cash receipts and cash disbursements. -Such bank reconciliations ensure that the entity's books reflect the same balance as the bank balance after considering reconciling items. -Controls can be improved further if an independent party such as the internal auditor reviews the bank reconciliation.

How does an imprest account help to improve control over cash?

-An *imprest bank account* contains a stipulated amount of money, and the account is used for limited purposes. -Imprest accounts are frequently used for disbursing payroll and dividend checks. -An *imprest account* serves as a clearing account for similar types of checks. -By separating similar types of checks, the entity facilitates the disbursement of cash while maintaining adequate control over cash. -Use of imprest accounts also minimizes the time necessary to reconcile the general cash account.

What is one approach used by auditors to test for kiting?

-An approach used by auditors to test for kiting is the preparation of an interbank transfer schedule. -With an interbank transfer schedule, the auditor tests the dates of cash disbursements and the cash receipt for each transfer to assure that the transfer is properly recorded.

Why are analytical procedures of limited use in the audit of the cash balance?

-Because of the residual nature of cash, it *does not have a predictable relationship to other financial statement accounts*. -As a result, the auditor's use of analytical procedures for auditing cash is *limited to comparisons with prior years' cash balances* and to budgeted amounts.

How does the fair value evidence the auditor is likely to gather differ between Level 1 and Level 3 assets?

-Fair value audit evidence for Level 1 is objective and market-based so the auditor will obtain fair values from publicly available sources (e.g., finance website). -Level 3 fair value evidence will involve examining management's assumptions and subjective inputs to valuation models. -Complicated financial instruments, such as credit default swaps, asset-backed securities, and collateralized debt obligations, among others, may not be traded on active markets, making accurate valuation of such instruments difficult. -The auditor will likely need to involve a valuation specialist.

How does an entity's controls over cash receipts and disbursements affect the nature and extent of the auditor's substantive tests of cash balances?

-The reliability of an entity's control activities over cash receipts and cash disbursements affects the nature and extent of the auditor's substantive tests of cash balances. -The effective operation of these control activities provides strong evidence that the *completeness assertion* is being met.

What offsets the analytical procedures of limited use in the audit of the cash balance?

-This limited use of analytical procedures is normally offset by: (1) extensive tests of controls and/or substantive tests of transactions for cash receipts and cash disbursements or (2) extensive tests of the entity's bank reconciliations.

Imprest account.

A bank account containing a stipulated amount of money used for limited purposes (e.g., imprest accounts are frequently used for disbursing payroll and dividend checks).

Why does an auditor obtain a cutoff bank statement when auditing a bank account?

A cutoff bank statement is obtained to test the reconciling items included in the bank reconciliation.

Proof of cash.

A technique used to reconcile the cash receipts and disbursements recorded on the entity's books with the cash deposited into and disbursed from the entity's bank account for a specific time period.

Tests for kiting

An interbank transfer schedule is used to test for kiting (see Exhibit 16-5).

Tests of controls.

Audit procedures performed to test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the relevant assertion level.

Analytical procedures.

Evaluations of financial information made through analysis of plausible relationships among both financial and nonfinancial data.

Assertions.

Expressed or implied representations by management regarding the recognition, measurement, presentation, and disclosure of information in the financial statements and related disclosures.

Briefly describe the classification and valuation issues related to investments in debt and equity securities.

FASB ASC Topic 320, "Investments - Debt and Equity Securities," requires that investments be classified in three categories and accounted for as follows: -Debt securities that the entity has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. -Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. -Debt or equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale and are reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity. The auditor must also determine if there has been any permanent decline in the value of an investment security. Auditing standards provide guidance for determining whether a decline in value below amortized cost is other than temporary.

Identify the primary financial statement assertion relative to investments that would be addressed by each procedure: Determine that all transfers among held-to-maturity, trading, and available-for-sale securities have been properly authorized and recorded.

Primary Assertion: Authorization and Presentation and disclosure—classification, accuracy Objective: To determine that transfers are properly authorized and that the financial statement presentation and disclosure of investments is in conformity with generally accepted accounting principles consistently applied.

Identify the primary financial statement assertion relative to investments that would be addressed by each procedure: Determine that income from investments has been properly recorded as accrued or collected by reference to published sources, by computation, and by tracing to recorded amounts.

Primary Assertion: Completeness Objective: To determine that all income and related collections from the investments are properly recorded.

Identify the primary financial statement assertion relative to investments that would be addressed by each procedure: Obtain positive confirmation of the investments held by any independent custodian as of the balance sheet date.

Primary Assertion: Existence or occurrence Objective: To determine that the custodian holds the securities as identified in the confirmation.

Identify the primary financial statement assertion relative to investments that would be addressed by each procedure: Determine that any other-than-temporary decline in the price of an investment has been properly recorded.

Primary Assertion: Valuation and allocation Objective: To determine that the market or other value of the investments is fairly stated and the loss is properly recognized and recorded.

Identify the primary financial statement assertion relative to investments that would be addressed by each procedure: For investments in nonpublic entities, compare carrying value to information in the most recently available audited financial statements.

Primary Assertion: Valuation or allocation Objective: To determine that the market or other value of the investments is fairly stated.

Cash equivalents.

Short-term, highly liquid investments that are readily convertible to cash or so near their maturity that there is little risk of change in their value (e.g., money market funds, Treasury bills).

Tests of details of account balances and disclosures.

Substantive tests that concentrate on the details of items contained in the account balance and disclosure.

Substantive tests of transactions.

Tests to detect errors or fraud in individual transactions.

Reliance strategy.

The auditor's decision to rely on the entity's controls, test those controls, and reduce the direct tests of the financial statement accounts.

*WORD PROBLEM* Cassandra Corporation, a manufacturing company, periodically invests large sums in investment (debt and equity) securities. The investment policy is established by the investment committee of the board of directors, and the treasurer is responsible for carrying out the investment committee's directives. All securities are stored in a bank safe-deposit vault. -The independent auditor's internal control questionnaire with respect to Cassandra's investments in debt and equity securities contains the following three questions: 1) Is investment policy established by the investment committee of the board of directors? 2) Is the treasurer solely responsible for carrying out the investment committee's directives? 3) Are all securities stored in a bank safe-deposit vault? -In addition to these three questions, what questions should the auditor's internal control questionnaire include with respect to the company's investments in debt and equity securities? (AICPA, adapted)

The auditor's internal control questionnaire should include the following additional questions: -Does access to the bank safe-deposit vault require the signature or presence of two designated persons? -Are all individuals who have access to marketable securities bonded? -Are those who have access to the securities denied access to the accounting records? -Does the accounting department keep detailed records of 1) Purchases and sales? 2) Securities (including number of shares) owned? 3) Stock certificate numbers? 4) Dividend income? 5) Gains and losses? -Are all securities registered in the name of the company? -Are all securities periodically inspected? -Are the inspections performed on a surprise basis? -Is the physical inventory of securities reconciled with the accounting records? -Are all purchases and sales of securities executed by the treasurer within the directives of the investment committee? -Is the amount of dividends received on individual investments periodically reconciled to published public records? -Does the investment committee periodically review compliance with its established policy?

Proof of cash

The four-column proof of cash: (1) ensures that all cash receipts recorded in the entity's cash receipts journal were deposited in the entity's bank account, (2) ensures that all cash disbursements recorded in the entity's cash disbursements journal have cleared the entity's bank account, and (3) ensures that no bank transactions have been omitted from the entity's accounting records.

Identify the key segregation of investment-related duties and possible errors or fraud that can occur if this segregation is not present.

The key segregation of duties for investments and the errors or fraud that they can prevent are: *Segregation of Duties:* -The initiation function should be segregated from the final approval function. -The value-monitoring function should be segregated from the acquisition function. -Responsibility for maintaining the securities ledger should be separate from that of making entries in the general ledger. -Responsibility for custody of securities should be separate from that of accounting for the securities. *Possible Errors or Fraud as a Result of Conflicts in Duties:* -Fictitious transactions can be made or securities can be stolen. -Securities values can be improperly recorded or not reported to management. -Concealment of a defalcation that would normally be detected by reconciliation of subsidiary records with general ledger control accounts. -Theft of securities can be concealed.