Chapter 10. Finance and Investment Cycle

Chapter 10 Finance and Investment Cycle

Chapter Summary

·  The finance and investment cycle deals with the major activities of a typical business (1) obtaining funds to finance the operation either from lenders who become creditors or from investors who become owners, and (2) investing funds not immediately needed to finance operations. This chapter explains the flow of transactions of both the finance and investment activities, the accounts affected, and the elements of control within the cycle. A series of short cases is used to show the application of audit procedures in situations where errors and frauds might be discovered. The chapter includes inherent and control risk assessment for the financial and investment cycle.

·  Inherent Risks in the Finance and Investment Cycle

This cycle involves many complex transactions. When companies raise money by borrowing from banks, they are often required to agree to loan covenants that restrict the uses of cash and require maintenance of certain ratios. If these are violated, the companies can be forced to repay the loans immediately—potentially driving them out of business. Transactions in this cycle are often complex and may involve related parties. Such transactions are often difficult to account for, and may be easier to use for fraudulent activity. Also, auditors must consider if there has been impairment in investments that has to be accounted for. Finally, improper lease accounting has resulted in many recent restatements causing companies to reclassify operating leases to capital leases.

·  Financing and Investment Cycle: Typical Activities

The finance and investment cycle major functions are: (1) financial planning, (2) raising capital, and (3) entering into mergers, acquisitions, and other investments. The transactions in this cycle interact with the acquisition and expenditure, production and payroll, and revenue and collection cycles. The major accounts and records in the cycle are listed in Exhibit 10.2.

·  Financing Transactions: Debt and Stockholder Equity Capital. Transactions in debt and stockholder equity capital are normally few in number but large in monetary amount, and are handled by the highest level of management. The activities and transactions involve the following elements: (1) Authorization: Financial planning includes a cash flow forecast and capital budget. Authorizations for sale of stock and debt financing are usually at the board of directors level. (2) Custody: Large companies use registrars for custody of the stock certificate book. Small companies keep their own stockholders' records. Originals of debt instruments are held by lenders. (3) Record keeping: Notes, bonds payable, and calculated liabilities are maintained by accounting departments. (4) Periodic Reconciliation: Inspect and reconcile stock certificate book. Confirm bonds held by trustee.

·  Investing Transactions: Investments, and Intangibles. Transactions in investments and intangibles may vary depending on the size and type of company. The activities and transactions involve the following elements: (1) Authorization: Investments approved by the board of directors or investment committee. (2) Custody: Custody of investments and intangibles depend on the nature of the assets. Some investments may be in physical custody, others at brokers. (3) Record keeping: Investments and intangibles record keeping will vary depending on complexity and nature. (4) Periodic Reconciliation: Inspect and count negotiable security certificates.

·  Control Risk Assessment

Because finance and investment transactions are usually individually material, each transaction usually is audited in detail. Reliance on controls does not normally reduce the extent of substantive procedures on finance and investment cycle accounts. However, lack of control can lead to significant extended procedures.

·  Control over Accounting Estimates.

o  Responsibilities are mostly in the hands of senior management officials.

o  It is difficult to have strict segregation of functional responsibilities when senior management officials are involved.

o  A compensating control feature involving two or more persons in each kind of important functional responsibility helps offset the lack of segregation of duties.

·  Auditing Accounting Estimates. A client's management is responsible for making estimates and maintaining the controls designed to reduce the likelihood of material misstatements. Auditors' test of controls over estimates amounts to inquiries and observations related to the specific features of bstantive audit procedures include procedures to determine whether (a) the valuation principles are acceptable under GAAP, (b) the valuation principles are consistently applied, (c) the valuation principles are supported by the underlying documentation, and (d) the method of estimation and the significant assumptions are properly disclosed according to GAAP.

·  Control Risk Assessment for Notes Payable. An internal control questionnaire is presented in Appendix 10A to illustrate typical questions for the management assertions.

·  Summary: Control Risk Assessment. The involvement of senior officials in a relatively small number of high‑dollar translations makes control risk assessment a process tailored specifically to the company's bstantive procedures are not limited in extent. Auditors often test 100 percent of transactions and balances. Control deficiencies and unusual or complicated transactions can adjust the nature and timing of the audit procedures.

·  Financing Activities: Assertions and Substantive Procedures.

Long-Term Liabilities and Related Accounts. The primary audit concern is that all liabilities are recorded and that the interest expense is properly paid or accrued. The assertion of completeness is paramount. The typical specific assertions include:

o  All material long‑term liabilities are recorded.

o  Liabilities are properly classified according to their current or long‑term status.

o  New long‑term liabilities and debt payments are properly authorized.

o  Terms, conditions, and restrictions relating to noncurrent debt are adequately disclosed.

o  Disclosures of maturities for the next five years and the capital and operating lease disclosures are accurate and adequate.

o  All important contingencies are either accrued in the accounts or disclosed in footnotes.

·  An illustrative program of substantive audit procedures for notes payable and long‑term debt is in Appendix 10B-1.

·  Owners’ Equity. The typical specific assertions include:

o  The number of shares shown as issued is in fact issued.

o  No other shares have been issued and not recorded or reflected in the accounts and disclosures.

o  The accounting is proper for options, warrants, and other stock plans, and related disclosures are adequate.

o  The valuation of shares issued for non cash consideration is proper, and in conformity with accounting principles.

o  All owners' equity transactions have been authorized by the board of directors.

·  An illustrated program of substantive audit procedures for owners' equity is in Appendix 10B‑2.

Examples of concepts

Assertion	Control	Test of Controls	Substantive test
Items in liability and equity accounts exist	Debt agreements are approved by management and communicated to accounting.	Examine evidence of approval and communication to accounting.	Confirm debt balances with lenders and equity with registrar.
All debt and equity is recorded	Debt agreements are approved by management and communicated to accounting.	Examine evidence of approval and communication to accounting.	Confirm debt balances with lenders and equity with registrar.
Debt and equity are valued appropriately.	Competent employees understand accounting rules.	Inquire of employees as to their understanding.	Test computation of valuations.
Debt represents valid obligations.	Accounting employees are notified of terms of debt.	Examine debt agreements of for accounting notification.	Examine minutes and debt agreement.
Investments are presented in accordance with GAAP	Competent employees understand disclosure rules	Inquire of employees as to their understanding.	Examine minutes and debt agreements.

·  Investing Activities: Assertions and Audit Procedures.

Derivative Investments, Hedging Activities, and Investments in panies can have a wide variety of investments and relationships with affiliates. The typical specific assertions include:

o  Investment securities are on hand or held in safekeeping by a trustee.

o  The accounting for investment cost and fair value is appropriate.

o  Controlling investments are accounted for by the equity method.

o  Investment income has been received and recorded.

o  Investments are adequately classified and described in the balance sheet, including disclosures of restrictions, pledges, and liens.

o  Risk related to investment securities (especially derivative securities) has been properly disclosed.

·  An illustrative program of substantive audit procedures for investments, intangibles, and related accounts is in Appendix 10B‑3. For investment accounts consisting of a few large entries, the audit emphasis is on authorization of transactions and year‑end audit procedures.

·  Procedures for auditing fair value measurements are described in SAS 101. Generally, it is preferable to use market values. When there are no market values available, management must estimate what value the marketplace would have used.

·  Appendix 10A and 10B

An internal control questionnaire for notes payable and substantive audit programs for owners' equity, notes payable and long‑term debt, investments and related accounts are illustrated. Review these and ask yourself why the procedures are matched with their particular assertion (10A) or what assertion the procedure is testing (10B).

Examples of concepts

Assertion	Control	Test of Controls	Substantive test
Items in investment accounts exist.	Brokerage account statements examined and reconciled to general ledger.	Examine evidence of reconciliation.	Obtain confirmation from brokerage.
All investments are recorded.	Calls by trading desks are monitored.	Observe monitoring. Trace from broker's statements to recording.	Obtain confirmation from brokerage.
Investments are valued correctly.	Competent employees understand accounting rules.	Inquire of employees as to their understanding.	Trace investment values to market listings.
Investments are owned.	Accounting employees are notified of terms of acquisitions and sales.	Examine agreements of acquisitions and sales for accounting notification.	Examine minutes and acquisition or sales agreements.
Investments are presented in accordance with GAAP.	Competent employees understand disclosure rules.	Inquire of employees as to their understanding.	Examine minutes and acquisition or sales agreements.

Self-Assessment

True or False Questions

Indicate in the space provided whether the following statements are true or false.

_____ 1. Financial planning starts with the chief financial officer's cash flow forecast.

_____ 2. Sales of capital stock and debt financing transactions usually are authorized by the board of directors.

_____ 3. In large companies, custody of stock certificate books is a significant management problem.

_____ 4. Documenting ownership of bonds can be handled by a trustee having duties and responsibilities similar to those of registrars and transfer agents.

_____ 5. All investment policies should be approved by the board of directors or its investment committee.

_____ 6. The most significant reconciliation opportunities in the investment and intangible accounts are confirmation with brokers and the inspection and count of negotiable securities certificates.

_____ 7. Reliance on controls normally reduces the extent of substantive audit procedures on finance and investment cycle accounts.

_____ 8. The segregation of functional responsibilities is relatively easy for the finance and investment cycle.

_____ 9. Auditors' test of controls over the production of estimates amounts to inquiries and observations.

_____ 10. It is very common for auditors to perform substantive procedures on 100 percent of the

details in finance and investment accounts.

_____ 11. When there are no independent agents, most audit evidence about capital stock is gathered by

confirmation directly with the holders.

_____ 12. Owners' equity transactions usually are not well documented.

_____ 13. The primary audit concern with the verification of long‑term liabilities is that all liabilities are

recorded and that the interest expense is properly paid or accrued.

_____ 14. When fixed assets are acquired during the year under audit, auditors should inquire about the

source of funds for financing the new asset.

_____ 15. Confirmation requests should be sent only to lenders with a liability balance at the audit date.

_____ 16. Confirmation and inquiry procedures are not required for a class of items loosely termed

off‑balance sheet information.

_____ 17. The balance sheet classification of investments by management should be confirmed with outside parties.

_____ 18. The preferred source of fair values for investments is management's estimate of what the market value should be.

Completion Questions

Fill in the blank spaces with the word or words that complete the statement.

1.  A _____________________________ _____________________________ approved by the board of directors constitutes the authorization for capital asset acquisitions and investments.

2.  __________ - _________________ _____________________________ _____________________________ transactions are obligations and commitments that are not required to be recorded.

3.  A _____________________________ is a financial institution appointed to record issue and ownership of company securities.

4.  A _____________________________ _____________________________ handles the exchange of shares, canceling the shares surrendered by sellers and issuing new‑certificates to buyers.

5.  Records of interest rates and bonds payable are maintained by the _____________________________ _____________________________ and the _____________________________.

6.  Capital stock may be subject to _____________________________ when independent registrars and transfer agents are employed.

7.  The responsibility for financing and investment transactions is basically in the hands of _____________________________ _____________________________ _____________________________.

8.  A _____________________________ _____________________________ is a control feature used when a standard control procedure is not in place.

9.  An _____________________________ _____________________________ is an approximation of a financial statement element, item, or account.

10.  _____________________________ _____________________________ is responsible for making estimates and should have a _____________________________ and _____________________________ designed to reduce the likelihood of material misstatements in them.

11.  When circumstances call for extended procedures, information on outstanding stock may be _____________________________ _____________________________ ­­­_____ _____ _____________________________.

12.  The assertion of _____________________________ is paramount in the verification of long‑term liabilities and determination that all liabilities are recorded.

13.  The confirmation of notes payable to banks may use the _____________________________ _____________________________ confirmation.

14.  Investment accounting may be on the _____________________________ method, _____________________________ method, or _____________________________.

15.  _____________________________ _____________________________ _____________________________ of securities can prevent use of company securities as _____________________________ for personal loans.

16.  The primary audit concern with the verification of long-term liabilities is that all _________________ are recorded and that the ______________ _______________ is properly paid or _____________.

Multiple‑Choice Questions

Select the best answer for each of the following questions and enter the appropriate letter in the space provided.

_____ 1. The typical business activity of the financing and investment cycle that requires an accounting entry is

a. short‑ and long‑term forecasts.

b. meetings with investment bankers.

c. proposals to board of directors for investing excess monies.

d. investment of excess funds in temporary or long‑term securities.

_____ 2. If investments are kept by the company in a bank safe deposit box, ideally, which of the following two people should have access to the safe deposit box?

a. A director and president.

b. President and vice president for finance.

c. A director and vice president for finance.

d. A director and general ledger accountant.

_____ 3. Selecting a sample of notes payable transactions and vouching payments to cancelled checks is a test of the management assertion about

a. allocation.

pleteness.

c. existence.

d. presentation.

_____ 4. The typical assertion relating to investments and related accounts in a manufacturing company would not include the assertion that

a. all investments are valued at cost.

b. investment securities are on hand or held in safekeeping by a trustee.

c. investment income has been received and recorded.

d. investments are adequately classified and described in the balance sheet, including disclosures.

_____ 5. In an audit test of recorded interest expense and accrued interest the auditor was able to detect that the recorded interest expense was greater than the calculations showed. This may indicate

a. a failure to accrue interest.

b. interest payments are in default.

c. interest payments were charged to another account.

d. interest was paid on an unknown debt or unrecorded liability.

_____ 6. When auditing market value of an investment an auditor would be least likely to

a. Examine quoted market prices.

b. Evaluate management's procedure for determining market prices.

c. Make his/her own determination of market prices.

d. Confirm market prices with a broker.

_____ 7. When a company keeps its own stock records, which of the following procedures is not required?

a. confirm outstanding common stock with stock registrar agent.

b. inspect the stock record stubs for certificate numbers and number of shares.

c. inspect the unissued certificates.

d.  obtain written representation about the number of shares issued and outstanding.

_____ 8. Which of the following is not a typical assertion relating to owners' equity?

a. The number of shares shown as issued is in fact issued.

b. The accounting is proper for options, warrants, and other stock issue plans, and related disclosure is adequate.

c. All owners' equity transactions have been authorized by the board of directors.

d. The valuation of shares issued for non cash consideration is reflected at book value.

_____9. When auditing the valuation assertion of an equity method investment, which of the following is the auditor most likely to do?

a. Inspect stock certificates.

b. Obtain audited financial statements of the investee company.

c. Obtain the market price of the stock as of year end.

d. Review management's calculations.

_____10. An agent of a bond issuer who handles the administrative aspects of a loan and ensures that the borrower complies with the terms of the bond indenture is called a

a. registrar.

b. transfer agent.

c. trustee.

d. none of the above.

Problem

Your firm has been engaged to audit the financial statements of a new client, Ajax Corporation, with total assets of approximately $4,000,000, for the year ended December 31, 2004. As a member of the audit team, you have been asked to design an audit program for the notes payable account, which totaled about $500,000. Required: Prepare a detailed audit program for the examination of the notes payable account.

Solutions

True or False Questions

1. False 6. True 11. False 16. False

2. True 7. False 12. False 17. False

3. False 8. False 13. True 18. False

4. True 9. True 14. True

5. True 10. True 15. False

Completion Questions

1.  capital budget

2.  Off-balance sheet financing

3.  registrar

4.  transfer agent

5.  accounting department, CFO (or controller)

6.  confirmation

7.  senior management officials

8.  compensating control

9.  accounting estimate

10.  client's management, process, controls

11.  confirmed directly with the holders

12.  completeness

13.  standard bank

14.  cost, equity, consolidation

15.  proper custodial control, collateral

16.  liabilities, interest expense, accrued

Multiple‑Choice Questions

1. d 3. c 5. d 7. a 9. b

2. b 4. a 6. c 8. d 10. c

Problem

See Appendix 10B‑1 of the text, audit program for notes payable and long‑term debt.