Chapter 10 Finance and Investment Cycle Credit has

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 Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -2 INVESTING AND FINANCING CYCLE • 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; notes and bonds payable; and, stockholders' equity accounts.

10 -3 Inherent Risks • • • Lease Accounting Loan covenants Related party transactions Complex transactions Impairments

10 -4

10 -5 Investment and Finance Activities • • • Financial Planning Raise capital Operate business (all other cycles) Mergers and acquisitions Invest excess funds

10 -6 Exhibit 10. 2 Finance and Investment Cycle

10 -7 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

Finance and Investment Cycle: Control Procedures 10 -8 • 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 • Separation 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.

10 -9 CONTROL OVER ACCOUNTING ESTIMATES • • • Communication of need for estimate Accumulate data Qualified personnel Review and approval Comparison to results Compare with plans

10 -10 SUBSTANTIVE TESTS–INTERESTBEARING LIABILITIES • Agree to BEGINNING BALANCE and CONFIRM with holders or makers. • LOAN PROCEEDS – VOUCH to cash receipts – Recalculate Discount/Premium – Confirm IBL, examine note • LOAN PAYOFF – Recalculate Interest Expense – Recalculate Gain/Loss on Retirement – Verify cash disbursements

10 -11 INTEREST-BEARING LIABILITIES • 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.

10 -12 Exhibit 10. 4 Audit Documentation

10 -13 AUDITING STOCKHOLDER'S EQUITY • Overview of audit approach – EXTERNAL PARTIES involved in record keeping – Transactions must be authorized by the BOARD OF DIRECTORS – Transactions must be consistent with the client's ARTICLES OF INCORPORATION

10 -14 AUDITING STOCKHOLDER'S EQUITY • 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

10 -15 AUDITING STOCKHOLDER'S EQUITY • 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

10 -16 Auditing Investments: Substantive Procedures • 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

10 -17 Auditing Investments: Substantive Procedures (cont. ) • 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)

Trouble Spots in Audits of Investments 10 -18 • 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.

10 -19 Derivative Investments, Hedging Activities, and Investments in Securities (SAS 92) • Inquiries about the nature of investments and the reasons for holding them, especially hedging activities. • The classification affects the accounting treatment of market values and the unrealized gains and losses on investments. • Due to the complexity of SFAS 133 (Accounting for Derivative Securities and Hedging Activities), auditors may need special skills or knowledge to understand client hedging transactions, to ensure that effective controls are in place to monitor them, and to audit the transactions.

10 -20 Auditing Fair Value Measurements (SAS 101) • Management’s responsibility. • Market-based values preferred • If not available—use assumptions market would have used. • If not known—management can use their own assumptions – if no contrary data