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  • 1. AP-8: ⇒Audit Program for Investments Company Balance Sheet Date The company has the following general ledger accounts that are classified in the investments captions of the balance sheet: General Ledger Description or Brief Purpose Current or Number of the Account Noncurrent Asset? Audit Program for Investments Company Balance Sheet Date Audit N/A Workpaper Objectives Performed Index Audit Procedures for Consideration by FINANCIAL STATEMENT ASSERTIONS E/O Existence or occurrence. V/A Valuation or allocation. C Completeness. P/D Presentation and disclosure. R/O Rights and obligations.
  • 2. AUDIT OBJECTIVES A. The balances reflect a complete listing of investments, and the company’s ownership of such assets is evidenced by securities or other appropriate legal documents either physically on hand or held in safekeeping by others (assertions E/O, C, and R/O). B. Asset values, investment income or loss, valuation allowances, gains or losses on sales of investments, and changes in fair value are recorded and presented in accordance with GAAP (assertion V/A). C. Investments are properly described and classified in the balance sheet, and disclosures have been made for any restrictions, pledges, or liens against the assets. The disclosures required by GAAP have been made (assertion P/D). D. Derivatives are properly identified and measured as assets or liabilities, and changes in fair value are recorded and presented in accordance with GAAP. The disclosures required by GAAP have been made (assertions E/O, C, R/O, V/A, and P/D). IDENTIFICATION CODES The letters preceding each of the above audit objectives, i.e., A, B, etc., serve as identification codes. These codes are presented in the left column labeled “Audit Objectives” when a procedure accomplishes an objective. If the alpha code appears in a bracket, e.g., [A], [B], etc., the audit procedure only secondarily accomplishes the objective. If an asterisk precedes a procedure, it is a preliminary step or a follow up step that does not accomplish an objective. BASIC PROCEDURES A, B, C 1. For debt and equity securities: a. Obtain or prepare an analysis of activity during the year in the securities portfolio separated by classification type (trading, held-to-maturity, or available-for-sale). Test the clerical accuracy of the analysis. Trace the opening balances to the adjusted prior year working trial balance and the ending balances to the current year’s working trial balance. b. Inspect the securities on hand and confirm securities held by others. Retain copies of all confirmations in the workpapers. (1) The inspection should be performed in the presence of client personnel. Obtain a receipt evidencing the return of the securities to the custody of the client. (See CL-15, “Receipt for Securities Counted by Auditor.”)
  • 3. (2) Determine that the securities are made out to the client and that coupons, if appropriate, are attached. (3) Compare the securities inspected or confirmed to the portfolio activity obtained in Step 1a. c. Vouch the cost of significant purchases and the proceeds from significant sales. Document the items tested. Recompute the gain or loss from the sale of securities, noting that the method used in determining the cost of securities sold (specific identification; first-in, first-out; or average cost) was consistently applied. d. Test the reasonableness of current year dividend and interest income from investments if such income is material. Inspect published sources for dividends declared. Determine if dividends receivable should be accrued. Recompute amortization of discount or premium on bonds. e. Test the carrying value of the security portfolio. (1) Test the propriety of the classification of securities as trading, held-to-maturity, or available-for-sale. (2) Trace market values to published sources. (3) Recompute the unrealized gain or loss for each classification. (4) Determine that the unrealized gain or loss on the trading portfolio has been properly classified in the income statement and that the unrealized gain or loss on the available-for-sale portfolio has been properly classified in the equity section of the balance sheet. (Unrealized holding gains and losses on the available-for- sale portfolio should be reported as other comprehensive income.) (5) Determine that all transfers between the portfolios have been properly recorded in accordance with management’s authorization and note pertinent information for the management representation letter. (6) Determine that any other-than-temporary decline in value of securities available-for-sale or held-to-maturity has been properly recognized and accounted for. (7) Determine that unrealized gains and losses have been appropriately identified as temporary differences for purposes of computing deferred income taxes. f. From a review of bank confirmations, debt confirmations, debt agreements, directors’ minutes, inquiry of management, and physical inspection or confirmation of securities, determine whether any security has been pledged or assigned to others to secure debt. Summarize any such situations for disclosure. g. Review classification of securities as current or noncurrent.
  • 4. h. Summarize in the workpapers the financial statement disclosures required by SFAS No. 115, SFAS No. 107, and SFAS No. 133. i. Obtain a representation in the representation letter relating to the entity’s ability and intent to hold investments classified as held-to-maturity. An example representation letter is provided at CL-28. Practical Considerations: ¯ Most commercial businesses not in the financial services industry have limited investments in securities. Accordingly, this financial statement caption is usually immaterial. These procedures should only be performed if the company has material investments in securities. ¯ Often a company’s security activity can be obtained from monthly activity reports prepared by the broker who handled the trades. Photocopies of these documents can sometimes be used in lieu of preparing a separate workpaper schedule. If the company’s investments are held by a broker/dealer or bank trust department, consider whether a SAS No. 70 report on the service organization is needed to gain a sufficient understanding of internal control in order to plan the audit. See section 202. ¯ SAS No. 96, Audit Documentation, requires documentation of substantive tests of details involving inspection of documents to include identification of the items tested. The authors believe items tested can be identified by listing the items; by including a detail schedule in the workpapers, such as a detailed analysis of securities activity, on which the items are identified; or by documenting in the workpapers the source and selection criteria. For example: ¯¯ For tests of significant items, documentation may describe the auditor’s scope and the source of the items (for example, all securities purchases greater than $5,000 from the 20X2 portfolio activity analysis). ¯¯ For haphazard or random samples, documentation should include the identifying characteristics of the items (for example, the specific remittance numbers, check numbers, etc.). ¯¯ For systematic samples, documentation may indicate the source, starting point, and sampling interval (for example, a selection of checks from the cash disbursements journal for the period 1/1/X2 to 12/31/X2, starting with check number 2150 and selecting every 100th check thereafter). SAS No. 96 is effective for audits of financial statements for periods beginning on or after May 15, 2002, with early application permitted.
  • 5. ¯ SFAS No. 115 (as interpreted by FASB Technical Bulletin No. 94-1) requires that all debt securities and equity securities with readily determinable fair values be classified into one of three categories based on (1) the type of security and (2) management’s ability and intent to hold the investment. According to Paragraph 83 of SFAS No. 115, the classification of debt and equity securities should be documented by the entity. ¯ In evaluating management’s intent and ability regarding investment classification, the auditor should: ¯¯ Obtain an understanding of management’s process for classifying securities as trading, available-for-sale, or held-to- maturity. ¯¯ Consider whether the company’s past activities corroborate or conflict with its stated intent. For example, the auditor should question management’s intent if the company has sold investment securities classified as held-to-maturity for reasons other than those identified in SFAS No. 115, Paragraphs 8 and 11. ¯¯ Inspect documentation of management’s intent. (Documentation of the classification of debt and equity securities may be informal.) ¯¯ Determine whether management’s activities, contractual agreements, or the company’s financial condition provide evidence of management’s ability to hold the investment. ¯ SFAS No. 130, Reporting Comprehensive Income, requires unrealized gains and losses on securities classified as available-for- sale to be recognized as a separate component of other comprehensive income. PPC’s Guide to Preparing Financial Statements includes guidance on reporting comprehensive income. ¯ Auditors should determine whether GAAP specifies the method to be used to determine fair value and whether the company’s determination of fair value is consistent with the specified method. For example, if a quoted market price is available, SFAS No. 115 requires fair value to be determined using the number of trading units of a security times the quoted market price. ¯ If the auditor is unable to corroborate fair value from quoted market prices (for example, for securities that do not trade frequently), the auditor should consider obtaining estimates of fair value from broker-dealers or other third-party sources. If fair value estimates are obtained from broker-dealers or other third-parties, the auditor should consider the guidance in SAS No. 70, Service Organizations, or SAS No. 73, Using the Work of a Specialist. (The general procedures program at AP-1 includes additional
  • 6. procedures addressing the use of a specialist.) ¯ If a security is valued using a valuation model, such as the present value of future cash flows, auditors should perform procedures such as assessing the reasonableness and appropriateness of the model, developing an independent expectation of the fair value estimate, or comparing the fair value with subsequent or recent transactions. Auditors should consider the guidance in SAS No. 57, Auditing Accounting Estimates, on obtaining and evaluating evidence supporting significant accounting estimates and SAS No. 73 on using the work of a specialist. However, a valuation model should not be used to determine the fair value of securities that are required to be valued using quoted market prices. ¯ When inspecting securities, it is important not to be left alone with the securities. Also, it may not be necessary to inspect all securities, for example, while individually significant items should be examined, it may not be necessary to examine all other securities. ¯ Illustrations of confirmation letters for securities in safekeeping at outside locations are presented at CL-16 and CL-17. ¯ Investments should be confirmed and inspected as of the same date. Also, assets held at multiple facilities should be inspected simultaneously. This ensures that assets are not moved from one location to another to make it appear that all assets are properly accounted for. ¯ If the auditor, based on his or her consideration of fraud risk factors, decides to modify procedures related to investments, the auditor should consider evaluating the legitimacy and financial viability of the custodian when confirming material investments. This includes verifying the proper address of the custodian. When inspecting security certificates, the auditor should insist on seeing originals rather than copies. The auditor should also consider whether securities in the hands of an outside custodian, such as securities held by a broker, are susceptible to theft by means of instructions to the broker to make trades that can be allocated to another entity or individual. ¯ The auditor should usually confirm the description of each asset held by a third party as well as the par or principal amount, number of shares, and total amount of the investment. If the auditor, based on his or her consideration of fraud risk factors, decides to modify procedures related to investments, consider confirming all transactions during the period with the broker, including purchases, sales, dividend and interest collections, and interest and other expenses paid. The confirmation may also seek
  • 7. verification of additional information such as who is authorized to make investment transactions, where interest and dividend dollars are sent, etc. ¯ Many small businesses do not have the internal ability to properly record transactions for significant portfolios of securities. Thus, the auditor normally is required to propose entries necessary to adjust the general ledger for accounting treatment necessary under GAAP. Consider using your paraprofessional staff prior to the start of the audit to perform this work and to prepare necessary schedules. ¯ SFAS No. 115 states that debt securities should not be classified as held-to-maturity if the entity has the intent to hold the security for only an indefinite period. For example, securities should not be classified as held-to-maturity if the security will be available to be sold in response to changes in the following: ¯¯ Market interest rates and prepayment risk. ¯¯ Liquidity demands. ¯¯ Availability or yield of alternative investments. ¯¯ Funding sources and terms. ¯¯ Foreign currency risk. ¯ In addition, SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, precludes a security from being classified as held-to-maturity if contract terms allow for the debt security to be repaid or otherwise settled in such a way that results in the holder not recovering substantially all of its recorded investment. ¯ When determining whether an other-than-temporary impairment condition exists, the auditor should evaluate whether management has considered relevant information to determine the existence of the following factors: ¯¯ Fair value is significantly below cost and: — The decline in fair value can be attributed to adverse conditions specifically related to the security or to specific industry or geographic conditions. — The company does not have the ability or intent to hold the investment for a sufficient time period to allow for any anticipated recovery in fair value. — The decline in fair value has existed for an extended period of time. ¯¯ A rating agency has downgraded a debt security’s rating. ¯¯ The financial condition of the security’s issuer has
  • 8. deteriorated. ¯¯ Scheduled interest payments on debt securities have not been made or dividends have been reduced or eliminated on equity securities. ¯¯ Losses from the security have been recorded by the company subsequent to year end. Evidence should be obtained about these factors and auditors should consider whether the evidence corroborates or conflicts with management’s conclusion about whether an other-than-temporary impairment exists. ¯ When testing the propriety of classifying debt securities as held-to-maturity, the auditor should evaluate whether the company has the ability to hold debt securities until maturity. Consideration should be given to the following factors: ¯¯ The company’s financial position, working capital needs, and operating results. ¯¯ Debt agreements, guarantees, alternate sources of liquidity, or other contractual obligations. ¯¯ Laws or regulations. ¯¯ Existing operating and cash flow projections or forecasts. A, B, C 2. For investments in closely held corporations, partnerships, or joint ventures: a. Determine the proper method of accounting for the investment (cost, equity, or consolidation) by inquiry about management’s ability to exercise significant influence and by inspecting appropriate securities or legal documents supporting ownership. Include in the current or permanent workpaper files abstracts or copies of significant agreements examined to evaluate appropriate accounting. b. Examine the latest copies of the financial statements or tax return of the investee to determine the materiality of the investee operations to that of the client. If the investment is material, or if the financial statements of the investee have a significant effect on the client’s carrying value of the investment, perform additional procedures. Practical Considerations: ¯ For most small businesses, investments in closely held businesses are immaterial and the above procedures are normally adequate. However, additional procedures should be performed when such investments are material.
  • 9. ¯ Management’s inability to obtain information from an investee may suggest that the client does not have the ability to exercise significant influence. ¯ If an investment is accounted for contrary to the presumption established by GAAP for use of the equity method (for example, if an investment of 20% to 50% is accounted for using the cost method), auditors should obtain evidence supporting that the presumption has been overcome and should determine that the reasons for not following the presumption are appropriately disclosed. D 3. Inquire of the most knowledgeable client representative (in a larger company, this may be the treasurer) about the extent of the company’s derivative use, the types of derivatives used, and the company’s purpose in using these instruments. Practical Considerations: ¯ The auditor’s inquiries should address aspects of the company’s operations that might present risks hedged using derivatives. Risks hedged using derivatives may be present, for example, if the company is in the financial services industry, conducts business with foreign entities, or is in an industry where commodity contracts are common. Auditors should also inquire about whether the company has converted interest-bearing debt from fixed to variable or variable to fixed using derivatives. ¯ Examples of derivatives include commodity or financial put or call options; commodity, financial instrument, or foreign-currency forwards or futures; and interest-rate or other swaps, caps, or collars. Derivatives may be used for risk management (for example, fair value, cash flow, or foreign currency hedges) or for investment. Derivatives may be freestanding contracts or may be embedded in other contracts. Section 1002 discusses common uses of derivatives in more detail. ¯ If the entity has significant derivative transactions, see the additional procedures to this program for further evaluation. ¯ If the company is in a specialized industry, such as an investment company, hedge fund, or broker-dealer, or if the company engages in derivatives trading activities, additional procedures generally will be necessary. Auditors can also refer to the specialized industry audit guides published by the AICPA for guidance on auditing companies in specific industries, such as securities broker-dealers or investment companies. ¯ SAS No. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities, provides guidance for
  • 10. auditing derivatives. The AICPA has issued a companion Audit Guide that provides practical guidance and includes suggested procedures to clarify and illustrate the application of the requirements of SAS No. 92. * 4. Consider the need to apply one or more additional procedures. The decision to apply additional procedures should be based on a consideration of whether information obtained or misstatements detected by performing substantive tests or from other sources during the audit alter your judgment about the need to obtain a further understanding of control activities, the assessed level of risk of material misstatements (whether caused by error or fraud), and on an evaluation of whether the basic procedures have been sufficient to achieve the audit objectives. Attach audit program sheets to document additional procedures. Practical Considerations: ¯ Certain common additional procedures relating to the following topics are illustrated following this program: ¯¯ Investments in closely held corporations, partnerships, or joint ventures. ¯¯ Fair value disclosures. ¯¯ Derivatives. ¯¯ Additional procedures in response to fraud risk assessment. ¯ Practitioners may refer to PPC’s Guide to Fraud Investigations for more extensive fraud detection procedures if it is suspected that the financial statements are materially misstated due to fraud. * 5. Consider whether procedures performed are adequate to respond to identified fraud risk factors. If fraud risk factors or other conditions are identified that require an additional audit response, consider those risk factors or conditions and the auditor’s response in connection with the performance of Step 11 in AP-1b. Practical Consideration: ¯ Specific responses to identified fraud risk factors are addressed in individual audit programs. In connection with evaluation and other completion procedures in AP-1b, the auditor considers the need to perform additional procedures based on the results of procedures performed in the individual audit programs and the cumulative knowledge gained from performing those procedures. * 6. Consider whether the results of audit procedures indicate
  • 11. reportable conditions in internal control and, if so, add to the memo of points for the communication of reportable conditions. (See section 1504 for examples of reportable conditions, and see CX-18 for a worksheet that can be used to document the points as they are encountered during the audit.) CONCLUSION We have performed procedures sufficient to achieve the audit objectives for investments and related allowance accounts, and the results of these procedures are adequately documented in the accompanying workpapers. (If you are unable to conclude on any objective, prepare a memo documenting your reason.) ⇒Additional Audit Procedures for Investments Instructions: Additional procedures will occasionally be necessary on some small business engagements. The following listing, although not all-inclusive, represents common additional procedures and their related objectives. Investments in Closely Held Corporations, Partnerships, or Joint Ventures A, B, C For material investments in closely held corporations, partnerships, or joint ventures, perform the following procedures: a. Vouch the client’s ownership interest by inspecting appropriate securities or legal documents supporting ownership. b. Inquire as to whether the client has the ability to exercise significant influence over financial and operating policies of the investee and the basis for the conclusion. Evaluate the results of the inquiry in relation to facts obtained during the audit. c. Based on the information obtained in Steps a and b, determine the proper accounting method for recording the investment, i.e., full consolidation, equity method, or cost. If the
  • 12. method has changed because of a change during the year in ownership interest, determine the effect on the auditor’s report and financial statements, for example, explanatory paragraph referring to the change and disclosure in the notes. d. For investments accounted for using the cost method, vouch the cost (unless it was vouched previously). Review the latest financial statements of the investee, make inquiries of management, etc., to determine if there has been any other-than- temporary decline in value of the investment. From a review of bank confirmations, debt confirmations, debt agreements, minutes and inquiries of management, determine whether the investment has been pledged or assigned to others to secure debt. e. For investments accounted for using the consolidation or equity method: (1) Inspect audited financial statements of the investee to verify the carrying value of the investment and the current year income or loss attributed to such investment. If such statements are not available, obtain unaudited financial statements or tax returns of the investee and apply appropriate audit procedures to test the reasonableness of the carrying value of the investment and the current year income or loss attributed to such investment. (2) Determine that the financial statements of the investee are on the same accounting basis as your client and that the fiscal year end of the investee coincides with your client’s (or is within three months). (3) Test the accuracy and completeness of the client’s entry(ies) to consolidate or to record the investment on the equity basis. (a) If the consolidation method is used, test the propriety of eliminating entries for intercompany profit. Also determine that the auditor’s report, financial statements, and related notes are appropriate for consolidated financial statements. (b) If the equity method is used, tie current year’s income or loss recognition (after eliminating significant intercompany profit) to the appropriate revenue account. (4) Evaluate the effect on the client’s financial statements of report qualifications, contingencies, etc., of the investee. (This is appropriate for both the consolidation and equity methods.) (5) Determine that any other-than-temporary decline in value of investments accounted for using the equity method have been properly recognized and accounted for. (6) To identify subsequent events or transactions occurring after the date of the investee’s financial statements but before the date of the report on the company’s financial statements, read available interim financial statements of the investee and make
  • 13. necessary inquiries of the client’s management. (7) Obtain evidence of material transactions between the client and the equity investee to determine if intercompany profits and losses are properly eliminated and appropriate related-party disclosures are made in the client’s financial statements. (8) Determine that differences in book and tax recognition of income and losses are identified for purposes of computing deferred taxes. (9) Summarize in the workpapers the information needed to prepare the required note disclosures. Practical Considerations: ¯ SAS No. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities, establishes the audit requirements for significant long-term investments. Evidential matter examined for such investments normally should include audited financial statements of the investee. If unaudited data is used, the auditor should apply appropriate audit procedures to such data. If another audit firm performs the audit or additional procedures on the investee, the investor’s auditor should also consult SAS No. 1, AU 543, Part of Audit Performed by Other Independent Auditors. ¯ Financial statements of an investee that have been audited by an auditor whose report is satisfactory to the investor’s auditor may constitute sufficient evidential matter in support of the carrying value of an investment and the current year income or loss attributed to the investment. If the auditor determines that additional evidence is needed, however, he or she should perform additional procedures such as reviewing information about the investee in the investor’s files and making inquiries of investor management about the investee’s financial results. If the audit report on the investee’s financial statements is not satisfactory to the investor’s auditor, he or she should apply, or arrange to have another auditor apply, appropriate audit procedures to such data. ¯ If the carrying amount of the investment in the investor’s financial statements reflects factors that are not recognized in the investee’s financial statements, such as goodwill or fair values of assets that differ materially from the investee’s carrying amounts, auditors should obtain sufficient evidence to support those amounts. ¯ An often overlooked problem of applying consolidation or equity accounting to an investment in another company is forgetting to determine if the investor and the investee are on the same basis of accounting. If the financial statements of the investor are on the accrual basis, the financial statements of the investee should also be on the accrual basis. If the basis of accounting of the
  • 14. investee is not converted to agree with the investor before applying consolidation or equity accounting, and the auditor believes the effect is material, the auditor’s report should be qualified for a departure from GAAP. However, if the investee operates in a specialized industry that follows a specialized basis of accounting, that basis of accounting should be retained in the financial statements of the investor. ¯ Another often asked question is whether the date of the results of operations of the investor must coincide with the results of operations of the investee. In other words, if the financial statements of the investor are dated December 31, 20X1, must the equity in earnings of the investee also be recorded through December 31, 20X1? ARB 51 indicates that where the difference is not more than about three months, it usually is acceptable to use the investee’s statements for its fiscal period; when this is done, recognition should be given by disclosure or otherwise to the effect of intervening events that materially affect the financial position or results of operations. ¯ The investor’s share of losses of an investee may equal or exceed the carrying amount of an investment accounted for by the equity method. The investor normally should discontinue applying the equity method when the investment is reduced to zero. However, APB Opinion No. 18 also states that if the investor has guaranteed obligations of the investee or is otherwise committed to provide further financial support, losses should continue to be recorded by the investor to the extent of additional funds committed. (See also AICPA Technical Practice Aid TIS 2220.12.) An investment that has been reduced below zero should be presented as a liability in the balance sheet of the investor. ¯ When accounting for investments in other entities, the auditor should also be aware that an “except for” qualification or disclaimer in the audit report on the investee’s financial statements, if material, could affect the report on the investor’s financial statements. Fair Value Disclosures C Obtain information about the fair values of financial instruments (e.g., securities and investments in closely held companies other than those accounted for under the equity method) for disclosure in the financial statements. Practical Considerations: ¯ SFAS No. 126, Exemption from Certain Required Disclosures
  • 15. about Financial Instruments for Certain Nonpublic Entities: An Amendment of SFAS No. 107, makes SFAS No. 107’s disclosures about the fair value of financial instruments optional for companies that meet the following criteria: ¯¯ The company is a nonpublic company. ¯¯ The company’s total assets are less than $100 million on the date of the financial statements. ¯¯ The company has no instrument that, in whole or in part, is accounted for as a derivative instrument under SFAS No. 133 during the reporting period. ¯ In many small businesses, securities are not material. However, when they are material, fair value will already have been determined to comply with the requirements of SFAS No. 115. For investments classified as trading securities or available-for-sale securities under SFAS No. 115, the only additional disclosures required by SFAS No. 107 are of the methods and significant assumptions used in the fair value estimate. For investments classified as held-to-maturity under SFAS No. 115, disclosure of fair value would also be needed. ¯ In most small businesses, determination of the fair value of investments in closely held companies is not practicable and, thus, is not required under SFAS No. 107. ¯ SFAS No. 107 does not apply to investments accounted for by the equity method. However, when a quoted market price is available, APB Opinion No. 18 requires disclosure of the market value of such investments. ¯ Paragraph 60 of SFAS No. 107 allows companies to use simplified assumptions to estimate fair value of financial instruments. Consequently, it is important that the methods and significant assumptions used in the estimates are disclosed. ¯ SFAS No. 107 states that “quoted prices, if available, are the best evidence of fair value of financial instruments.” However, it does not specify whether the bid price, the asked price, or some combination of the two qualifies as the quoted price. Some entities use the last bid price on the balance sheet date to estimate the fair value of assets. No matter which value is selected, the authors recommend that the method used be disclosed. ¯ Interpretation No. 1 of SAS No. 57, Auditing Accounting Estimates (AU 9342), addresses auditing the client’s fair value estimates for disclosures required by SFAS No. 107. The Interpretation requires that the auditor obtain sufficient competent evidence to provide reasonable assurance that: ¯¯ Valuation principles are in accordance with SFAS No. 107,
  • 16. consistently applied, and supported by underlying documentation. ¯¯ The method of estimation and significant assumptions used are properly disclosed. ¯ AU 9342 provides additional guidance for situations in which the client chooses to provide voluntary fair value information in addition to that required by SFAS No. 107. ¯ SFAS No. 107 does not require that fair values of financial instruments be estimated if it is not practicable, or cost effective, to develop the estimates. The decision of whether it is practicable should consider such things as the importance of the financial instrument to the client’s business activities and the materiality of the carrying amount of the financial instrument to the financial statements. ¯ When it is not practicable to estimate the fair value of a financial instrument, disclosure must be made of: ¯¯ Information pertinent to estimating the fair value of the financial instrument. ¯¯ The reasons why it is not practicable to estimate fair value. ¯ If a fair value estimate is based on the work of an outside specialist (e.g., an appraiser), the requirements of SAS No. 73, Using the Work of a Specialist, should be followed. The additional procedures to AP-1 contain audit procedures regarding using the work of a specialist. Derivatives D For entities with significant derivative transactions, perform the following steps: a. Read board of directors’ minutes for approval of derivatives transactions. b. Read loan agreements, bond indentures, lease agreements, insurance contracts and other relevant contracts to identify embedded derivatives. Determine whether embedded derivatives should be accounted for separately from the host contract in accordance with SFAS No. 133. Include in the current or permanent workpaper files abstracts or copies of significant agreements examined to evaluate the appropriate accounting for embedded derivatives. c. Confirm with counterparties or executing brokers the outstanding transactions as of the balance sheet date. Consider also confirming with counterparties or executing brokers the derivatives activity during the year. Scan derivatives activity and compare it with the description of the entity’s use of derivatives
  • 17. provided by the client. Retain copies of all confirmations in the workpapers. d. Compare the terms of individual transactions with contracts or trade tickets. e. For derivatives designated as hedging instruments: (1) Determine that the hedged item meets the SFAS No. 133 criteria for designation as a hedge. (2) Review the company’s documentation of the hedging relationship to ensure it meets the documentation requirements of SFAS No. 133. (3) Obtain an understanding of the methods used to determine whether the hedge is highly effective and to determine the ineffective portion of the hedge. Determine that management has assessed the effectiveness of the hedging relationship at inception and whenever financial statements are prepared, or at least every three months, noting that the method of assessing hedge effectiveness is the same as the criteria prescribed by the documentation prepared at the inception of the hedge. f. Test the valuation of the derivatives at year end. (1) Trace fair values to quoted prices, if available (for example, quoted market prices for derivatives listed on national exchanges and quoted market prices from broker-dealers who are market makers). If quoted market prices are not available, perform appropriate tests based on the valuation method used. (2) Test the measurement of the realized and unrealized gain or loss for derivative contracts. (3) Determine whether the unrealized gain or loss on the instruments has been properly classified. (4) If the derivative has been designated as a fair value hedge, determine that the change in fair value of the hedged item has been accounted for in accordance with SFAS No. 133. (5) For cash flow hedges of forecasted transactions, evaluate management’s determination about whether the forecasted transaction is probable of occurring. g. Consider whether counterparties have the financial strength to participate in the agreement. h. Summarize in the workpapers the financial statement disclosures required by SFAS No. 133. i. Obtain management representations regarding the existence and completeness of derivative transactions, appropriate characteristics of hedges, management’s intent and ability to enter into forecasted transactions for which hedge accounting is applied, and proper valuation of derivatives. j. Review tax attributes of derivatives transactions in conjunction with overall tax accrual audit procedures.
  • 18. Practical Considerations: ¯ SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, requires all entities to measure derivative instruments at fair value and recognize them as either assets or liabilities in the balance sheet. SFAS No. 133 also includes significant disclosure requirements. ¯ A derivative instrument may be a stand-alone contract or it may be embedded in another contract, such as a loan agreement, bond, or lease agreement. In some cases, SFAS No. 133 requires the embedded derivative to be accounted for separately from the host contract. ¯ Section 1002 provides an overview of the accounting and auditing considerations related to derivatives. Chapter 20 of PPC’s Guide to Preparing Financial Statements provides an in-depth discussion on accounting for derivatives. ¯ Auditors should use the assessed levels of inherent risk and control risk for assertions about derivatives to determine the nature, timing, and extent of substantive tests of derivatives. SAS No. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities, provides examples of considerations that might affect the auditor’s assessment of inherent and control risk for assertions about derivatives. ¯ Auditors should identify, understand, and differentiate the ways the company uses derivatives and tailor auditing procedures for each type of use. The AICPA Audit Guide, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities, provides practical guidance for auditing derivatives. The Audit Guide includes case studies covering various types of derivatives, such as swaps, options, forwards, and futures, as well as embedded derivatives. ¯ The company’s documentation of the hedging relationship should include identification of the hedging instrument, the hedged item, and the nature of the risk being hedged; the company’s risk management objective and strategy for entering into the hedge; and the method of assessing hedge effectiveness. ¯ Confirmations can be used as a substantive test of various assertions about derivatives. For example, confirmations can be designed to obtain information about (1) settled or unsettled transactions with a counterparty, (2) valuation assertions or underlying assumptions, (3) the existence of side agreements that affect the company’s rights and obligations, (4) the terms of an agreement that significantly impact whether an embedded derivative is accounted for separately, or (5) whether the contract will settle net or result in physical delivery. ¯ Because derivatives may not involve an initial net investment,
  • 19. when designing tests for completeness, auditors should not focus exclusively on evidence relating to cash receipts and disbursements. Substantive tests for completeness include: ¯¯ Confirming the existence of special terms or side agreements. ¯¯ Confirming the existence of derivatives with counterparties who are frequently used, but with whom the accounting records indicate there are currently no derivatives. ¯¯ Performing analytical procedures. ¯¯ Inspecting documentation for activity after year end that may indicate the existence of derivatives at year end. ¯¯ Reading other information, such as the minutes of board of directors’ meetings. In more sophisticated organizations, it may be difficult to limit audit risk for assertions about the completeness of derivatives to an acceptable level without performing tests of controls. ¯ If a service organization provides services that are part of the company’s information system for derivatives, it may be difficult to limit audit risk for assertions about the completeness of derivatives to an acceptable level without obtaining evidential matter about the operating effectiveness of the service organization’s controls. ¯ If quoted market prices are obtained from broker-dealers who are market makers for certain derivatives or through the National Quotation Bureau, special knowledge may be required to understand the circumstances in which the quote was developed. ¯ If quoted prices are not available, fair value estimates might be obtained from broker-dealers or other third-party sources, or determined by the entity using a valuation model. ¯¯ If the client determines the fair value by using a modeling technique, auditors should perform procedures such as assessing the reasonableness and appropriateness of the model, developing an independent expectation of the fair value estimate, or comparing the fair value with subsequent or recent transactions. ¯¯ If the fair value is obtained from a third-party source, such as a pricing service, the guidance in SAS No. 70, Service Organizations, may apply. If the third-party source derives fair value by using modeling or similar techniques, the guidance in SAS No. 73, Using the Work of a Specialist, may apply. ¯ In evaluating the reasonableness of the fair value of derivatives calculated using a model, auditors should concentrate on key factors and assumptions that are significant to the estimate, sensitive to variations, inconsistent with historical patterns, or subjective and susceptible to bias. Sensitivity analysis of key factors may help determine how they affect the estimate. ¯ SFAS No. 133 does not provide an exemption from the
  • 20. requirement to determine the fair value of derivatives (for example, because it is not practicable to do so). Thus, companies are required to determine fair value in all circumstances. Valuation techniques for measuring derivatives should be consistent with the objective of measuring fair value. Chapter 20 of PPC’s Guide to Preparing Financial Statements discusses common methods of determining the fair value of derivatives. ¯ Evaluating evidential matter for assertions about derivatives may require the use of considerable judgment. In situations requiring considerable judgment, auditors should consider the guidance in SAS No. 57, Auditing Accounting Estimates, and SAS No. 73. ¯ For cash flow hedges of forecasted transactions, the determination about whether the forecasted transaction is probable of occurring should not be based solely on management’s intent. The probability should be supported by observable facts and circumstances such as: ¯¯ The frequency with which similar past transactions have occurred. ¯¯ The ability of the company, both financially and operationally, to carry out the transaction. ¯¯ The extent of the loss that could result if the transaction does not occur. ¯¯ The likelihood of using transactions with substantially different characteristics to achieve the same business objectives. Additional Procedures in Response to Fraud Risk Assessment A, B If the auditor, based on his or her consideration of fraud risk factors, decides to modify procedures related to investments, the following procedures should also be considered: a. Obtain and review all contracts, agreements, and other documents related to investments, including actual stock or bond certificates, broker’s statements, and other applicable documents. Obtain an analysis of investment activity for the period. Practical Consideration: ¯ If possible, these documents should be obtained from a source other than the employee responsible for the custody and recording of investments and related activity. The analysis of investment activity should be obtained directly from executing brokers. b. Perform analytical procedures that are predictive tests of investment-related income and expenses.
  • 21. Practical Consideration: ¯ These analytical procedures generally involve recalculation of investment income and expense based on balances, rates, and time lapsed. If significant differences are noted between the predicted amount and the recorded amount, the reasons for the differences should be identified. c. Use the information obtained in Step a above and from confirmation procedures (see basic procedures Step 1) to trace all transactions (both realized and unrealized) to the appropriate accounts. Practical Consideration: ¯ This procedure should be used to match anticipated receipts of income or sales proceeds to actual receipts (bank memos, deposit slips, etc.). d. Review all investment-related journal entries and trace to supporting documents if not already reviewed when performing procedures a–c. Practical Consideration: ¯ Practitioners may refer to PPC’s Guide to Fraud Investigations for more extensive fraud detection procedures if it is suspected that the financial statements are materially misstated due to fraud. ⇒Additional Audit Procedures for Investments Beginning Balance in Initial Audit Company Balance Sheet Date Audit N/A Workpaper Objectives Performed Index Audit Procedures for Consideration by Instructions: Additional procedures will be necessary in an initial audit. These procedures are applied to opening balances and differ depending whether you are relying on your review of a predecessor’s work or placing no reliance on a predecessor’s audit. (Section 1803 discusses considerations when replacing a predecessor auditor, including a discussion of what the term reliance means when used in this program.) These procedures may be applied in conjunction with the basic procedures applied to the ending balance. The asterisks preceding the procedures indicate that they are an intermediate step in achieving audit objectives for the ending balance.
  • 22. * 1. If a predecessor’s audit of the prior period’s financial statements is to be relied on: a. Scan the predecessor’s workpaper analysis of the activity in the securities portfolio during the prior period; consider: (1) Reasonableness of securities values. (2) Reasonableness of investment income. (3) Reasonableness of gains or losses on sales of securities. (4) Appropriateness of financial statement classification, disclosure, and valuation, and the adequacy of the predecessor’s procedures to support these matters. b. Scan the predecessor’s workpapers for investments in closely held corporations, partnerships, or joint ventures; consider: (1) Appropriateness of the accounting method for the investment (cost, equity, consolidation) and the adequacy of the procedures supporting that determination. (2) Reasonableness of the carrying value and any related income or loss and the adequacy of the procedures to support those amounts. (3) For equity investments, consider the adequacy of the procedures to support the investor’s ability to exercise significant influence, allocation, if any, of original purchase cost between tangible assets and goodwill, and appropriateness of increases (income) and decreases (losses and dividends received) since acquisition. c. Scan the predecessor’s workpapers for derivatives; consider: (1) The adequacy of procedures performed to test for completeness. (2) The appropriateness of the accounting for derivatives designated as hedging instruments and the adequacy of procedures supporting that determination. (3) The reasonableness of the valuation of derivatives and the realized and unrealized gains and losses for derivative contracts and the adequacy of procedures to support those amounts. d. Consider whether any changes in classification or carrying value made in the current period should have been made in prior periods. Practical Consideration: ¯ The adequacy of the predecessor’s procedures should be considered in light of the materiality of the investment. The
  • 23. materiality evaluation determines whether the basis of comparison should be the basic procedures or the additional procedures of the audit program for investments. * 2. If no reliance on a predecessor is planned or possible and the investment in marketable debt or equity securities is material: a. Obtain or prepare a schedule of securities in the opening balance, reconcile to the general ledger accounts, and compare to the closing schedule of the current period. b. In vouching significant sales during the current period, trace to the opening schedule. c. Scan any significant sales of securities in the prior period, note the method of determining cost, and compare to the method used in the current period. d. Consider whether any changes in classification or carrying value made in the current period should have been made in prior periods. Practical Consideration: ¯ These procedures supplement the additional procedures applied when the investment in securities is material in the current period. * 3. If no reliance on a predecessor is planned or possible and an investment in a closely held corporation, partnership, or joint venture is material: a. Consider whether any changes in the accounting method or recognition of impairment of value in the current period should have been made in prior periods. b. For investments accounted for using the equity method: (1) Inquire about whether the client’s ability to exercise significant influence has changed over the period the investment has been held. (2) Consider the appropriateness of the allocation, if any, of original purchase cost between tangible assets and goodwill. (3) Scan a summary of the activity in the investment account from the original investment to the end of the current period. (4) Consider whether the inspection of the financial statements of the investee for the current period supports the reasonableness of the opening investment balance. Practical Consideration: ¯ These procedures supplement the additional procedures
  • 24. applied when an investment in a closely held corporation, partnership, or joint venture is material. * 4. If no reliance on a predecessor is planned or possible and derivatives are material: a. Obtain or prepare a schedule of derivatives in the opening balance, reconcile to the general ledger accounts, and compare to the closing schedule of the current period. b. Consider whether tests of activity in the current period provide evidence about the existence and valuation of derivatives in the opening balance. c. For derivatives designated as hedging instruments, evaluate whether the method of assessing hedge effectiveness is the same as the criteria prescribed by the documentation prepared at the inception of the hedge. d. For cash flow hedges of forecasted transactions, inspect evidence of the occurrence of those forecasted transactions. e. Consider whether any changes in classification or carrying value made in the current period should have been made in prior periods. Practical Consideration: ¯ These procedures supplement the additional procedures applied when derivatives are material.