PRACTICAL AUDITING Prepared by: Roda R.

Santos

Module 6
INVESTMENTS IN FINANCIAL INSTRUMENTS

EXPECTED LEARNING OUTCOMES

After reading this chapter, you should be able to

(a) apply the new IFRS 9 for classification, initial recognition, measurement and presentation of
financial assets in the statement of financial position;
(b) identify internal control procedures relating to investment securities 3;
(c) state the auditor's principal objectives in auditing investments and related revenues;
(d) apply audit procedures to establish management's assertions on investments and related
revenue balances;
(e) prepare working papers to establish correct balances of investments and related revenues
(f) formulate audit adjustments to bring investments and related revenues to correct balances;
and
(g) evaluate the appropriateness of the presentation of investments and related revenues in the
financial statements.

INVESTMENT CLASSIFICATION, INITIAL RECOGNITION AND MEASUREMENT

Investments in financial instruments consist principally of government bonds, commercial papers,

stock certificates and treasury bills. Because these financial instruments are readily negotiable,
the need for their physical protection and for strong internal controls is almost as great as in the
case of cash.

Based on level of ownership and management's intent for holding the Investment, investment in
equity securities are classified under the following classifications:

A. Equity investments at fair value through profit or loss (FVPL);

B. Equity investments at fair value through other comprehensive Income (FVOCI);
C. Investment in associate (or joint venture).

This chapter discusses some salient features of IFRS 9 relating to equity and debt
investments. Equity investments in associate or joint venture are within the scope of IAS 28 and
are also discussed briefly in the succeeding paragraphs.

Equity investments held primarily for trading and non-trading equity investments in which the
enterprise does not elect to designate such as at fair value through other comprehensive income
belong to the category of investments at fair value through profit or loss (FVPL). These
investments are presented as current assets in a properly classified statement of financial
position. FVPL are initially measured at purchase price and at reporting date are reported at fair
value. The change in fair value during the reporting period is recognized in profit or loss.

Equity investments not held for trading but ownership interest is not enough to give the
investor ability to exercise significant influence over the investee are also measured at fair value.
On the date of initial recognition, the entity may exercise its option to recognize the change in the
fair value through other comprehensive income.

In such a case, they are initially recognized at purchase price plus directly attributable
transaction costs. At reporting date, they are measured at fair value, with change in fair value
during the reporting period reported as component of other comprehensive income. The
accumulated balance of the holding gains and losses is a component of equity in the equity
section of the statement of financial position. Investments in this classification are generally
classified as non-current assets in a properly classified statement of financial position.

When the enterprise does not elect to recognize the change in the fair value of non-trading
equity securities in other comprehensive income, then the change in fair value shall be recognized
in profit or loss, and the investments shall be designated as (FVPL). The irrevocable option to
PRACTICAL AUDITING Prepared by: Roda R. Santos

designate non-trading equity securities as either FVPL or FVOCI shall be exercised on the date
of initial recognition.

Investment in associate, which gives the holders significant influence over the operating and
financial policies of the investee are accounted for in the investor's consolidated financial
statements using the equity method. Under the equity method, the investments are initially
recognized at purchase price plus directly attributable transaction costs. The investment balance
is subsequently affected by the associate's transactions that affect its shareholders' equity. The
investor's proportionate share in profit (adjusted for amortization of difference between cost of
investment and underlying equity that affect measurement of profit or loss) and the investor's
proportionate share in other comprehensive income increases the investment balance. Dividends
received by the investor and the investor's proportionate share in losses of the associate (adjusted
for amortization of difference between cost of investment and underlying equity that affect
measurement of profit or loss) decrease the investment balance. At reporting date, the investment
is measured at carrying value, without regard to the fair value of the investments, unless objective
evidence exists that indicates that the investment is impaired.

The classification of debt investments shall be on the basis of both (a) the business model for
managing the financial asset and (b) the contractual cash flows characteristics of the financial
asset. The business model adopted by the enterprise applies to a portfolio of investments. Such
business model may be any of the following:

(a) the objective is to hold the assets to collect contractual cash flows that are solely payment
for principal and interest (SPPI):
(b) the objective is to hold to assets to collect contractual cash flows and also to sell the assets
when profit opportunity arises; and
(c) the objective is neither 1 nor 2 (generally to hold the financial assets for trading).

If the business model for the debt investment portfolio is (a) above and the entity does not use
the fair value measurement through profit or loss, the debt investments shall be classified as debt
investments measured at amortized cost.

If the business model for the investment portfolio is (b) above and the entity does not use the
fair value measurement through profit or loss, the debt investments shall be classified as debt
investments measured at fair value through other comprehensive income.

If the business model for investment portfolio is (c), or if the business model is (a) or (b) and
the enterprise elects to measure the assets at fair value through profit or loss, then the debt
investments shall be classified as at fair value through profit or loss.

The summary of the basic principles for financial assets that are within the scope of IFRS 9 is
outlined in the matrices that follow:

EQUITY INVESTMENTS
At Fair Value Through Other At Fair Value Through Profit
Comprehensive Income or Loss
Inclusion Securities not held for trading (a) Securities held for trading
for which the enterprise elects (b) Securities not held for
to recognize change in fair trading for which the enterprise
value through other did not elect measurement at
comprehensive income fair value through other
comprehensive income.
Initial recognition Purchase price plus Purchase price; transaction
transaction costs costs are taken to profit or
loss
Measurement after initial Fair value Fair value
recognition
Amount taken to other (a) Unrealized gains and None
comprehensive income losses
PRACTICAL AUDITING Prepared by: Roda R. Santos

(b) Realized gains and losses,

with no recycling to profit or
loss (but may be transferred
to Retained Earnings)
Amounts taken to profit or loss Dividends that are considered (a)Dividends that are
return on investments considered return on
investments
(b) Unrealized and realized
gains and losses.

DEBT INVESTMENTS
At Amortized Cost At Fair Value through At Fair Value through
Other Comprehensive Profit or Loss
Income
Inclusion Debt investments that Debt investments that (a) Debt investments
are held within the are held within the held for trading
business model of business model of (b) Debt investments
collecting contractual collecting contractual held within the
cash flows consisting cash flows and to sell, business model of
SPPI, and which the and which the collecting contractual
enterprise did not elect enterprise elected to cash flows consisting
to measure at fair value. recognize the change in SPPI, and which the
fair value through other enterprise elected to
comprehensive income. measure at fair value.
(c) Debt investments
held within the
business model of
collecting contractual
cash flows and to
sell, and which the
enterprise did not
elect to recognize the
change in FV through
OCI.

Initial At purchase price plus At purchase price plus At purchase price;

Recognition transaction costs transaction costs transaction costs are
taken to profit or loss.
Measurement At amortized cost, using At fair value, in a two- At fair value
After Initial the effective interest step process: (a) adjust
Recognition method. to amortized cost, and
(b) adjust to fair value
through OCI.
Amount taken None Unrealized gains and None
to other losses due to change in
comprehensive fair value, with recycling
income to profit or loss when
realized.
Amounts taken (a) Interest revenue (b) (a) Interest revenue (b) (a) Interest revenue, for
to profit or loss Realized gains and Realized gains and practicality based on
losses, including losses (recycled from nominal Interest; (b)
Impairment loss cumulative OCI), Unrealized and realized
Including impairment gains and losses.
loss

The new IFRS 9 applies a single principle for recognition of impairment loss on debt
instruments classified at amortized cost and at fair value through other comprehensive income.
PRACTICAL AUDITING Prepared by: Roda R. Santos

The impairment is done in three stages:

Stage 1: Set up an allowance upon initial recognition, based on 12-month expected credit losses

Stage 2: Set up an allowance (or recognize additional amount of impairment), based on lifetime
expected credit losses if there is significant deterioration in credit quality of the issuer since initial
recognition; interest revenue is based on carrying amount of the asset, before deducting the
allowance;

Stage 3: Recognize appropriate amount of allowance and impairment loss, based on lifetime
expected credit losses if there is objective evidence of impairment; interest revenue in subsequent
periods is based on net carrying amount of the debt investments (after deducting the related
allowance).

Internal Control Procedures

The major elements of adequate internal control over the investment securities focus on the
following:

● Separation of duties between the custody of the instruments, the maintenance of

accounting records and the authorization of purchases and disposals;
● Joint control (of at least two officials) over the investment securities, or the use of an
independent outside custodian;
● Complete detailed records of all securities owned, and the related revenue from interest
and dividends;
● Registration of securities in the name of the company;
● Periodic physical inspection of securities by an internal auditor or other independent
official;
● Preparation of a budget of investment revenue;
● Formulation and implementation of investment policies; and
● Registration of securities in the name of the company,

All purchases and sales of financial instruments should be authorized by the board of directors
or an investment committee or a designated company official. Acquisitions and disposals of
investments should be in accordance with established policies of the enterprise. If possible, the
management prepares a list of authorized investments, a file of authorized signatures. If
investments constitute a significant amount of resources, officials in charge of investments must
carry insurance and fidelity bonds.

Regular internal reports should be prepared for the investment revenue, gains and losses.
Debt securities yield interest income while equity securities yield dividend income. Dividend
income should be recognized when declared and interest Income should be recognized when
accrued. When investments are sold, they result in gains and losses. At yearend, there must be
an assurance that the investments are measured properly by comparing the ledger balance with
the quotations. To achieve this objective detailed or subsidiary records must be accurately
maintain based on established processing and recording procedures Journal entries that adjust
the investment balance must be authorized.

There is a risk that securities may be lost, stolen, destroyer or diverted, resulting in misapplied
resources and misstated accounts. Thus, the enterprise should establish barriers over investment
securities by keep.ng them in a safe deposit box under the joint control of two or more company
officials, or placing them in the custody of an independent safekeeping agent. Other than the
records maintained by the custodian of the instruments, there must be a separate record keeping
of transactions handled by another official or a designated responsible employee.
The count of securities on hand conducted by an internal auditor should be made concurrently
with the verification of other liquid assets, such as cash, Furthermore, the listing of investments
must be periodically reconciled with investment accounting records. Investment income must be
monitored and periodically calculated and verified
PRACTICAL AUDITING Prepared by: Roda R. Santos

Audit Objectives

The auditor's objectives in the audit of investments in financial instruments are to:

● consider internal control over financial instruments held by the client;

● determine the existence of investment and that the client has rights to the instruments;
● determine that all financial instruments held by the entity are reported and transactions
affecting the investments are properly accounted for (completeness);
● establish the proper measurement of investments in financial instruments;
● establish accuracy of the amounts recognized in profit or loss and other comprehensive
income relating to Investments, and
● determine that the presentation and disclosure of the investments is adequate.

Audit Procedures

To establish existence or occurrence of transactions, the auditor confirms balances with

the trustee or broker if the financial instruments are in the custody of an independent outside
entity. Confirmations should be as of the same date, so as to obtain a reasonable assurance that
there is no switching of securities to conceal a shortage. The confirmation should include the
description of each financial instrument held for the client, as well as par or principal amount,
number of shares and total amount of investment. The auditor may consider confirming all
transactions during the period with the broker, including sales, purchases, dividend and interest
collections as well as who is authorized to make investment transactions, and how investment
income proceeds are remitted to the company

If company officials keep custody of the instruments, the auditor should physically inspect
and count all securities on hand simultaneously. The auditor shall Inspect these securities
simultaneous with the count of cash items held by the concerned company officials. The auditor
shall inspect the securities in the presence of a client's officer or a trusted employee. Inspected
instruments shall be returned intact and the return must be properly documented.

Comparison of the serial numbers on securities with those recorded in the prior year's
audit working papers may reveal any substitution or "borrowing" of securities. Securities held as
collateral for loans should be confirmed by sending a request signed by the client but mailed by
the auditors with the reply directed to the auditor's office.

To establish completeness of account balances and recorded related transactions, a cutoff

test is conducted to obtain assurance that all investment transactions are recorded in the proper
reporting period. Analytical review procedures and other substantive tests, such as
recomputations of gains and losses, are applied to help determine whether recorded balances
are reasonable.

Dividend and interest revenue is usually verified by independent computations by the

auditors, or by tests of reasonableness of the amount of revenue earned. Dividend record books
published by investment advisory services show the amounts of dividends and dates of
declaration, of record, and of payment, Bond interest can be recomputed from the interest rates
and payment dates shown on the bonds.

The proper measurement of investments is validated by referring to published price

quotations for securities that are measured at fair value. If the securities do not have published
price quotations, the auditor shall consider obtaining estimates of fair value from security
dealers/brokers or other third party sources. in case of debt securities, auditors confirm loan
balances with debtors. If the client has securities that are accounted for on the equity basis of
accounting, the auditors should obtain recent audited financial statements of the investee to verify
the client's share of net assets and income from the investment. If such financial statements are
not available, the auditors may find it necessary to perform audit procedures to verify the
unaudited financial statements of the investee.
PRACTICAL AUDITING Prepared by: Roda R. Santos

The auditor should determine whether investments are properly classified and the
disclosure guidelines in the accounting standards are observed in the financial statements. In
doing so, the auditor has to obtain an understanding of management's process for classifying
securities as at fair value through profit or loss or at fair value through other comprehensive
income for equity securities, or at fair value through profit or loss or at amortized cost for debt
securities. The client's transactions affecting the investments, for example, selling investment
securities classified as at amortized cost (or Held to Maturity Securities), should be questioned
as this sale may
conflict with the intention of the management in acquiring these securities, and as thus, may result
in reclassification of the investments Investments in debt securities should not be designated as
at Amortized Cost (or Held to Maturity Securities) the security is sold in response to market
interest rates and prepayment risk, liquidity demands, availability of alternative investments and
foreign currency risk.

In determining whether the investment has to be subjected to impairment testing, the

auditor should determine whether management has considered relevant information to determine
the existence of impairment indicators such as adverse conditions specifically related to the
security or to specific industry or geographic conditions, deterioration of the investee's financial
condition, and continuous decline in the fair value of the securities. When indications for
impairment estar impairment loss has to be recognized in profit or loss for investments not
classified as at fair value through profit or loss.
PRACTICAL AUDITING Prepared by: Roda R. Santos

MULTIPLE CHOICE

1. Internal control over investments in financial instruments is enhanced when

A. securities are held by the company treasurer.
B. securities are held under joint control of at least two officials.
C. securities are registered in the name of the security broker.
D. securities are registered in the name of the company treasurer.

2. The auditors should conduct the count and inspection of securities held by a client as
investment in the presence of a client's representative in order to
A. acknowledge the receipt of securities returned.
B. obtain assistance in the physical count and inspection of the securities
C. detect switching of securities with other liquid assets of the entity.
D. detect forged signatures.

3. The auditors' count of the client's investment securities should be simultaneous with the
A. confirmation of accounts receivable.
B. count of cash balances.
C. count of inventories.
D. confirmation of accounts payable.

4. Jones was engaged to audit the financial statements of Gamma Corporation for the year
ended June 30, 20XX. Having completed an examination of the investment securities, which
of the following is the best method of verifying the accuracy of dividend income?
A. Tracing recorded dividend income to cash receipts records and validated deposit slips.
B. Utilizing analytical techniques and statistical sampling.
C. Comparing recorded dividends with amounts appearing on income tax return of the client.
D. Comparing recorded dividends with a standard financial reporting services record of
dividends.

5. A company's decision to use the fair value option rather than amortized ce for debt
investments is most likely to affect which of the following assertions the most?
A. Completeness
B. Existence
C. Measurement
D. Occurrence

6. When a client engages in transactions involving derivatives, the auditor should

A. develop an understanding of the economic substance of each derivative.
B. confirm with the client's broker whether the derivatives are for trading purposes.
C. notify the audit committee about the risks involved in derivative transactions
D. add an explanatory paragraph to the auditor's report describing the risks associated with
each derivative.

7. Which of the following is the most effective audit procedure for testing the reasonableness of
interest income on debt investments?
A. Tracing interest declarations to an independent record book.
B. Recomputing interest earned.
C. Confirming interest rate with the debtor.
D. Vouching the receipt and deposit of interest checks.

8. A company holds bearer bonds as temporary investment. Responsibility for the custody of
these bonds and submission of coupons for interest collections should be delegated to the
A. Chief accountant
B. Company president
C. Company treasurer
D. Internal auditor
PRACTICAL AUDITING Prepared by: Roda R. Santos

9. In establishing the existence and ownership of long-term investments in the form of publicly-
traded securities, an auditor most likely would
A. correspond with the investee company to verify the number of shares owned
B. confirm the number of shares owned that are held by an independent custodian.
C. apply analytical procedures to the dividend income and investment accounts.
D. inspect the cash receipts journal for amounts that could represent the sale of securities.

10. To establish the existence and ownership of an investment in ordinary shares of a publicly
held company, an auditor ordinarily performs a security count or
A. determines market share at the end of the reporting period using published price
quotation.
B. corresponds with the investee regarding the number of shares owned
C. relies on the internal control structure if the auditor has tested the controls and has
reasonable assurance they are operating as prescribed.
D. confirms the number of shares owned with an independent registrar