10 1 Chapter 10 Finance and Investment Cycle

10 -1 Chapter 10 Finance and Investment Cycle “Credit has done a thousand times more to enrich mankind than all the goldmines in the world. It has exalted labor, stimulated manufacture and pushed commerce over every sea. ” --Daniel Webster Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -2 Presentation Outline I. Overview of Finance and Investing Cycle II. Audit of Liabilities and Stockholders’ Equity III. Audit of Investments Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -3 I. Overview of Finance and Investing Cycle A. Investing and Financing Cycle Activities B. Inherent Risks C. Investment and Finance Activities D. Control Considerations E. Finance and Investment Cycle: Control Procedures F. Control Over Accounting Estimates Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -4 A. Investing and Financing Cycle Activities • Concerned with transactions related to the use of the organization's funds (investing) and sources of those funds (financing) other than operations. • Accounts affected by investing and financial cycle transactions include investments in securities; property, plant and equipment; notes and bonds payable; and, stockholders' equity accounts. Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

B. Inherent Risks • Lease Accounting – circumventing capital lease rules to remove debt from balance sheet. • Loan covenants – intentional misstatement to avoid having banks call loans. • Related party transactions – more risk because they are not at arms-length. • Complex transactions – transactions are often structured to get around GAAP. Makes them difficult and hard to audit. • Impairments – taking a big bath in bad years for investments to create reserves to reduce expenses in the future. Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved. 10 -5

10 -6 Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

C. Investment and Finance Activities 10 -7 • Financial Planning – cash flow planning and capital budgeting serve as controls. • Raise capital – signature approval of high-ranking officers and consent of board of directors. Registrars and transfer agents (p. 364) • Operate business (all other cycles) – all cycles interact with finance and investment cycle. • Mergers and acquisitions – involve sources and uses of funds. • Invest excess funds – earning a short-term return on excess cash. Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -8 D. Control Considerations • Transactions authorized by BOARD OF DIRECTORS • Documentation: – Investments in securities: BROKER'S ADVICE – Property, plant and equipment: VENDOR'S INVOICE (for purchased PPE) or INTERNAL COST RECORDS (for manufactured PPE) – Bonds and notes payable: Documentation from DEBTHOLDERS – Stockholders' Equity: Documentation from REGISTRAR • CASH RECEIPTS/DISBURSEMENTS JOURNALS Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

E. Finance and Investment Cycle: Control Procedures 10 -9 • Physical Controls – Securities numbered and in the client's name – Securities held by an independent custodian or in a secure location – Access to safe-deposit box requires the presence of more than one employee – Physical items periodically compared to detail records – Cash receipts from Investing and Financing cycle transactions deposited intact and daily • Segregation of Duties – Transactions AUTHORIZED by the Board of Directors – General Accounting RECORDS transactions – A separate function or external custodian has CUSTODY • Performance Reviews – Compare current investing and cycle transaction data against prioryear data or expected data – Compare revenue and expenses against organization standards or expectations. Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

F. Control Over Accounting Estimates 10 -10 A sample of accounting estimates are provided on the top of p. 368. Specific aspects of estimate development an auditor considers include: • Management emphasis on proper estimation • Accumulation of sufficient relevant data from reliable sources • Qualified personnel prepare estimates • Review and approval at appropriate levels of authority • Comparison of prior estimates to results to evaluate reliability of estimate approach. • Determine if estimates are consistent with current company plans and operations. Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -11 II. Audit of Liabilities and Stockholders’ Equity A. Substantive Testing for Interest-Bearing Liabilities B. Audit Documentation – Exhibit 10. 4 C. General Audit Concerns for Stockholders’ Equity D. Auditing Paid-in Capital E. Auditing Retained Earnings Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -12 A. Substantive Testing for Interest. Bearing Liabilities • Agree to BEGINNING BALANCE and CONFIRM with holders or makers. • LOAN PROCEEDS – VOUCH to cash receipts – Recalculate Discount/Premium – Examine note for interest, payment terms, collateral, debt covenants, etc. • LOAN PAYOFF – Recalculate Interest Expense – Recalculate Gain/Loss on Retirement – Verify cash disbursements Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -13 A. Substantive Testing for Interest. Bearing Liabilities (Continued) • INTEREST PAYMENTS – Recalculate Interest Expense • Search for UNRECORDED liabilities – – Inquiry of management Bank confirmations Unusual amounts of interest expense Large receipts of cash during the year • Ensure DEBT COVENANTS are met. – Inspect loan agreements. – Consider GOING CONCERN implications if not met. – Ensure proper presentation and disclosure. Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -14 B. Audit Documentation – Exhibit 10. 4 p. 371 Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -15 C. General Audit Concerns for Stockholders’ Equity • Overview of audit approach – EXTERNAL PARTIES involved in record keeping can confirm stockholders’ equity. Otherwise, items can be vouched to the certificate book stubs. – Transactions must be authorized by the BOARD OF DIRECTORS – Transactions must be consistent with the client's ARTICLES OF INCORPORATION Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -16 D. Auditing Paid-in Capital – Agree balances to prior year documentation – Examine issuances and repurchases of capital stock • Verify distribution of proceeds between CAPITAL STOCK and ADDITIONAL PAID-IN CAPITAL • Examine CASH RECEIPTS and CASH DISBURSEMENTS records • Determine that all transactions are RECORDED (TRACE from BOD minutes) • Verify that all transactions are PROPERLY AUTHORIZED Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -17 E. Auditing Retained Earnings – Agree beginning balance with prior year documentation – Verify the appropriateness of prior-period adjustment treatment – Trace net income/loss to INCOME STATEMENT – Ensure that DIVIDENDS are properly authorized by BOARD OF DIRECTORS Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -18 III. Audit of Investments A. Substantive Audit Procedures for Investments B. Trouble Spots in the Audit of Investments Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -19 A. Substantive Audit Procedures for Investments • Agree balances to Prior Year Documentation • Purchases of investments – VOUCH to BROKER'S ADVICE (Statement) – Examine BOARD MINUTES for authorization • Sales of investments – VOUCH to BROKER'S ADVICE, CASH RECEIPTS RECORDS, and BOARD MINUTES – Recalculate gain or loss on sale – Read minutes for sales of Investments and trace to recording Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -20 A. Substantive Audit Procedures for Investments (Continued) • Determine MARKET VALUE (SFAS 115) – Obtain 12/31 market price from Wall Street Journal or other sources – Evaluate for possible PERMANENT DECLINES • PHYSICALLY INSPECT or CONFIRM securities Verify Certificate Numbers to ensure that there were no unrecorded sales and subsequent repurchases – Made in company name – Can inspect at interim, if safe-deposit box • Verify DIVIDEND REVENUE – Examine CASH RECEIPTS records – Compare to external sources (Moody's, Standard & Poor's) • Evaluate presentation in BALANCE SHEET (short-term vs. long-term asset) Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

B. Trouble Spots in the Audit of Investments 10 -21 • Valuation of investments at cost, market, or value impairment that is other than temporary. • Propriety, effectiveness, and risk disclosure of derivative securities used as a hedges • Determination of the fair value of derivatives and securities, including valuation models and the reasonableness of key assumptions. • Determination of significant influence relationship for equity method investments. Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -22 Summary • Accounts involving Investments, Property-Plant and Equipment, Debt, and Equity • Inherent risk for leases, loan covenants, related parties, complex transactions, and big baths • Estimate process and evaluation • Audit of liabilities and stockholders’ equity • Value of investments and amount of investment income Mc. Graw-Hill/Irwin © 2007 by the Mc. Graw-Hill Companies, Inc. All rights reserved.