Audit of Investments PDF

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Summary

AUDIT OF INVESTMENTSIntroduction Investment is an asset held by an entity for purposes of accretion of wealth through distributions of dividends, interest and rentals or for capital appreciation or other benefits to be obtained. Investments are presented either as ‘current investments’ and ‘long-ter...

Description

AUDIT OF INVESTMENTS Introduction Investment is an asset held by an entity for purposes of accretion of wealth through distributions of dividends, interest and rentals or for capital appreciation or other benefits to be obtained. Investments are presented either as ‘current investments’ and ‘long-term investments.’ A current investment is an investment that is by its nature readily realizable and is intended to be held for not more than one year from the date on which such investment is made. A Long-term investment is an investment other than a current investment. Quick review: Purpose of Investments

Investment        

Purpose

Investment in Equity Instruments – Financial Asset at fair value Investment in Equity Instruments – Associate Investment in Equity Instruments – Subsidiary Investment in Equity Instruments – Joint Venture Investment in Debt Investments Investment in special purpose funds

To earn from changes in fair value and dividends

Investment in Derivatives Investment in life Insurance policies – Cash surrender value

To earn from changes in fair value To compensate the entity from the untimely death of key officers

To benefit from exercising significant influence over another entity To benefit from exercising control over another entity To benefit from exercising joint control over another entity To earn from changes in fair value and interest To accumulate funds for basically any purpose such as plant expansion and long-term debt retirement

Audit of Investments in a nutshell: 1. Understand the Client’s investing activities The complexity of auditing entity’s investments always going to be different because for entities with simple investment instruments, auditing does not require much tedious work. One of the primary audit procedures might be to confirm its existence. Under other conditions, complex investments or entities with large investment portfolio, however, require additional work such as auditing values. As investment complexity increases, so will the need for more highly competent audit team members (those that can thoroughly understand unusual investments). Inherent Risk Assessment The inherent risk for an assertion about an investment is its susceptibility to a material misstatement, assuming there are no related controls. Factors that might affect the auditor's assessment of inherent risk for assertions about an investment include the following:  The complexity of the features of the investment.  Whether external factors affect the assertion. 2.

Internal Control Evaluation The auditor should carefully evaluate and study the system of internal control for audit clients that have large investment portfolio to determine the nature, timing and extent of audit procedures. Since it has several investments related transactions, the auditor should decide whether it would be more efficient to conduct test of control before substantive test. Before he opts to decide to rely on test of control, the auditor should ascertain the following internal control regarding investments:  Control over acquisition, accretion and disposal of investments  Safeguarding of investments  Controls relating to title to investments  Information controls Control Risk Assessment After obtaining the understanding of internal control over investment transactions, the auditor should assess control risk for the related assertions. If the auditor plans to assess control risk at less than maximum for one or more assertions regarding investments, the auditor should identify specific controls relevant to the assertions that are likely to prevent or detect material misstatements and gather audit evidence about their operating effectiveness.

PRIMARY SUBSTANTIVE TESTS The auditor should use the assessed levels of inherent risk and control risk for assertions about investments to determine the nature, timing, and extent of the substantive procedures to be performed to detect material misstatements of the financial statement assertions. Some substantive procedures address more than one assertion about various investment transactions. 

Management Assertion: Existence and Rights

Audit Objectives:  All recorded investments in the statement of financial position exist.  The entity owns, or has legal right to the investments included on the statement of financial position. Audit Procedures: The auditor’s procedure depends whether the securities or evidence of ownership are held by the client or third party.  If the securities or evidence of ownership is held by the client, the auditor counts the securities or instruments on hand with simultaneous count of cash and other negotiable instrument to prevent substitution.  If held by third party, the auditor will confirm to the custodian or arrange for a visit to the custodian and conduct a count.  For investment properties, arrange for an ocular inspection of investment properties and trace back acquisition of investment properties to acquisition documents. Documents/Files needed:  Stock certificates  Confirmation letter1  Deed of sale and other title transfer papers

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Management Assertion: Completeness

Audit Objectives:  To determine that investments to which the company has title to are all included in the statement of financial position.

Audit Procedures:  Trace selected purchases and sales of securities and other investments during the year.  Inspect securities on hand.  Obtain confirmation of securities held by others. Document/Files needed:  Stock certificates  Deed of sale and other title transfer papers  BOD’s minutes of meeting 

Management Assertion: Occurrence and Valuation and Allocation

Audit Objectives:  All recorded income from investments has accrued to the entity at the reporting date.  To determine that investments are valued properly in accordance with applicable PFRS. Audit Procedures:  The Accounting method and impairment test on investments of the client depends on the applicable PFRS. Therefore, the procedure applied by the auditor depends on the type of investment. Level of Influence

% of ownership

Accounting Method

Classification of Investment

Applicable PFRS

Little or none

50%

Consolidation

Investment in Subsidiary

PFRS 10

Joint Control

No quantitative presumption

Equity

Investment in Joint Venture

PAS 28

For Investment under Fair value method: The auditor should examine whether at initial measurement, in computing the cost directly attributable to investments, has been expensed outright (for FA-FVTPL) or was capitalized in the cost of investments (FA-FVOCI) – In accordance with Application Guidance of PFRS 9. The auditor should ascertain the fair value of the quoted securities from official quotations of the Philippine Stock Exchange. And in case of unquoted securities, the auditor should ascertain if it was measured in accordance with Application Guidance B5.4.14 of PFRS 9 (For FA@FV). In which, equity instruments must be measured at fair value and at cost in case fair value cannot reliably measured. For Investment under Equity Method: The auditor should verify the share in net income or loss by examining the audited financial statement of the investee and making independent calculation. For dividends received, the auditor can examine published dividend record of the investee. For Investment under Consolidation: The auditor should verify the beginning balance of the investment for the current year, the auditor will normally refer to its prior working paper. The auditor will also examine any addition or disposal by examining supporting documentation. Test Impairments of Investment Test of Impairment will also depend on the applicable PFRS which is to be considered by the auditor in evaluating the impairment made by the management. The auditor should also inquire with the management in their methods in identifying impairment. Document/Files needed:  Audited financial statement of investee  PSE quotations

OTHER SUBSTANTIVE TESTS 

Management Assertion: Accuracy

Audit Objective: 

Amounts and other data relating to recorded transactions and events have been recorded appropriately.

Audit Procedures:  Evaluating the accounting methods used and test the valuation.  Investigating current and potential impairments of investments. o Inquire with management their approach in identifying indicators of impairment, and the actions taken as a result of any potential impairment noted. o Evaluate the appropriateness of the valuation model and assumptions used. o Assess the reasonableness of management’s estimates. o Evaluate the accuracy, completeness, and relevance of the important data on which the estimates or measurements are based. Documents/Files needed:  Audited Financial Statement of Investee  Management Assertion: Classification Audit Objective:  Income statement related items are appropriately recorded in the proper accounts in the statement of comprehensive income. Audit Procedures:  Reviewing appropriateness of presentation and adequacy of disclosure of investments including related account.  Discuss with the entity the process used by management in classifying its investments. Documents/Files needed:  Audited Financial Statement of Investee  Management Assertion: Presentation & Disclosure Audit Objectives:  Investments and related investment income accounts are properly classified, described, and disclosed in the financial statements, including notes, in accordance with the applicable PFRS.  All investment pledged or other security interests are adequately and properly disclosed. Audit Procedures:  Reviewing board of directors’ (BOD) minutes of meetings, shareholders meeting, committee meetings and agreements and confirmation replies. o Gather evidence regarding authorization, liens, and pledges. o Disclose unrecorded purchases and sales of securities or other financial instruments.  Reviewing appropriateness of presentation and adequacy of disclosure of investments including related account. o Determine the applicable PFRS in the proper classification and presentation of investments in the statement of financial position and necessary disclosures. o Determine that the related income statement accounts are correctly recorded in profit or loss or as a component of other comprehensive income. Documents/Files needed:  Minutes of BOD meeting  Audited Financial Statement of Investee  Other evidence to determine current value of investments 

Management Representations The auditor should obtain from the management of the entity a written statement regarding classification and valuation of investments for Balance Sheet purposes. While such a representation letter serves as a formal acknowledgment of the management's responsibilities with regard to investments, it does not relieve the auditor of his responsibility for performing audit procedures to obtain sufficient appropriate audit evidence to form the basis for the expression of his opinion on the financial information. It may be mentioned that the representations made in the letter can alternatively be included in the composite representation letter usually issued by the management to the auditor. 

Documentation The auditor should maintain adequate working papers regarding audit of investments. Among others, he should maintain on his audit file, the management representation letter concerning investments.

SITUATIONAL PROBLEMS SITUATIONAL PROBLEM NO. 1 – ABC Ltd.

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Outline of the case: ABC Ltd. has a material investment in XYZ Co., a foreign subsidiary whose net worth has been fully/substantially eroded. The management has not provided any evidence of how they valued the investment to conclude on the carrying amount. The auditor was also unable to obtain sufficient appropriate audit evidence about the carrying amount of ABC Ltd.’s investment in XYZ Co. as at 31 st March 20XX, because they were denied access to the financial information, management & the auditors of XYZ Co., due to the collision between the two entities. Discussions on the case: There is an issue on the valuation assertion of the investments of the ABC Ltd., since there is uncertainty as to how the management had come up with the carrying amount of its investments in the XYZ Co. Assertions about the valuation of investments address whether the amounts reported in the financial statements through measurement or disclosure were determined in conformity with generally accepted accounting principles (GAAP), to which in this case, it cannot be determined since there are limitations on the data that the auditor can access. Tests of valuation assertions should be designed according to the valuation method used for the measurement or disclosure. The GAAP may require that an instrument be valued based on cost, the investee's financial results, or fair value. Also, the GAAP for securities may vary depending on the type of security, the nature of the transaction, management's objectives related to the security, and the type of entity. What the auditor may do is to seek the financial statements readily available in the website of the Securities and Exchange Commission (SEC), so that he may study the financial status of the XYZ Co. to see if the investments of the ABC Ltd. are properly valued. He may also see the quotations in the active market for the like investments as reference. SITUATIONAL PROBLEM NO. 2 – PMO Co.

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Outline of the case: Justin, the investment custodian of PMO Co., stole more than $2 Million from the company to finance his gambling addiction, as well as to pay for his rent and his car. To cover up for his theft, he manipulated the statement of financial position of the company by intentionally overstating its assets by increasing the investments presented. Discussions on the case: There is an issue on the existence and rights and obligations assertions over the investments as there are investments that may not exist, or could have existed but the company may not have the rights over, as at yearend due to the intentional overstatement made by the investment custodian to cover up for his theft. The existence assertion addresses whether the investments reported in the financial statements through recognition or disclosure exist at the date of the statement of financial position. Since he made these overstatements, he may present files to support his claims, so the auditor may perform measures to confirm his claims. He may choose among the following procedures to ascertain the existence assertion such as doing a physical inspection of the investm ent contracts and vouching these, doing a bank confirmation for investments held as mortgage or safe custody, doing a confirmation with the issuer of the securities and ask if there are indeed investments made by the company and if how much is the investment, or by doing a confirmation of the settled, as well as the unsettled, transactions with the broker-dealer or its counterparty. Also, it is always a good idea to check the minutes of the corporate meetings to confirm the authorization to purchase and sell each investment, as these matters are always written in the minutes. SITUATIONAL PROBLEM NO. 3 – YG Inc.

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Outline of the case: Sandy is auditing the financial statements of YG Inc. for the year ended 20x8. As a result of her audit, she found out that there are some investments and investment-related income accounts that were omitted from the general ledger by the investment custodian. She has confirmed that not all investment-related interest and dividend income has hit the income statement as revenue and that some investment income hitting the income statement can’t be matched to an investment, which means that not all investments are reflecting on the balance sheet.

Discussions on the case: The issue lies in the completeness and accuracy assertions the company had over its recorded investments. Completeness assertion addresses whether all of the entity's derivatives and securities are reported in the financial statements through recognition or disclosure. They also address whether all investment-related transactions are reported in the financial statements as a part of earnings, other comprehensive income, or cash flows or through disclosure. To test a client’s investments, auditors mostly look at how a security is categorized and whether it’s presented on the client’s income statement or balance sheet. The accuracy assertion states that all information disclosed are in the correct amounts, and reflect their proper values. Since there are some values that cannot be matched to any investment account, there is an issue on the company’s assertion on the accuracy of its recorded investments. The auditor may opt to calculate expected income with reference to supporting documents and compare them with the recorded income. She may also obtain or prepare a lead schedule of investments, and trace last year’s balances with last year’s working papers, c heck arithmetical accuracy of the schedule and trace totals of the schedule to general ledger control account and balance sheet. Comparing previous and current account detail may also help to identify the assets that have been removed from the accounts and testing those items further to determine that the criteria for sales treatment have been met. She may also do a confirmation with the issuers of the investment items, to know if there really an investment that exists and if there is, how much is it. She also may opt to do an inspection of the entries in investments and related income accounts. She may check additions and sales, inspect board of directors minutes for authorization of sales and purchases of investments, or re-compute gain or loss on sale of investments, if any. SITUATIONAL PROBLEM NO. 4 – WorldCom

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Outline of the case: WorldCom recorded operating expenses as investments. Apparently, the company felt that office pens, pencils, and paper were an investment in the future of the company and, therefore, capitalized the cost of these items over a number of years. In total, $3.8 billion worth of normal operating expenses, which should all be recorded as expenses for the fiscal year in which they were incurred, were treated as investments and were recorded over a number of years. This little accounting trick grossly exaggerated profits for the year the expenses were incurred. Discussions on the case: Assertions about presentation and disclosure address whether the classification, description, and disclosure of the investments in the entity's financial statements are in conformity with generally accepted accounting principles. The issue here is that the company has recorded the supposedly operating expenses as investments, which will result into the overstatement of its reported investment. In evaluating the adequacy of presentation and disclosure, the auditor should consider the form, arrangement, and content of the financial statements and their notes, including, for example, the terminology used, the amount of detail given, the classification of items in the statements, and the bases of amounts reported. What the auditor may opt to do is to check the disclosures written in the notes to the financial statements of the company and see how the company has presented the investments, as the breakdown for the investments are usually disclosed in there. SITUATIONAL PROBLEM NO. 5 – SMV Company

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Outline of the case: The financial statements of SMV Co. for the year 20xA has been audited by Russel. During the course of his audit, he found out that some of the investments of the company are improperly valued due to their complexity and management’s lack of accounting knowledge in recording and classifying them. The auditor is thinking of hiring an investment specialist to value these investments. Discussions on the case: Wh...