Dealagdon, Kyle L.

SBAC3D

Review Questions

1. The CPAs would accept a confirmation of the securities on hand from the custodian in lieu of
their personal inspection of the securities after they had investigated and satisfied themselves
as to the standing of the custodian. The CPAs would probably be satisfied if they found the
custodian to be a well-known, reliable financial institution, completely independent of the client
and with resources substantially larger in amount than the securities of the CPAs’ client that are
on deposit
2. The auditors can make an independent computations of dividends earned during the year by
reference to dividend record books published by investment advisory services.
3. Securities owned by the client may not be on hand at the balance sheet date because
they are held by others for safekeeping, pledged as collateral for loans, deposited as
assurance of performance under contracts, or in the hands of brokers or others for
transfer.
4. When the inspection of securities cannot be made for two weeks after the balance
sheet date, the client at the auditors’ suggestion may instruct the bank that the safe-
deposit box is not to be opened until the time of the auditors’ inspection. A letter may
be obtained from the bank stating that the box has not been opened between the
balance sheet date and the auditors’ arrival. If the securities are in the client’s office, it
will be necessary to verify any security transactions between the date of inspection and
the balance sheet date and to reconcile the results of the inspection with the securities
owned at the balance sheet date. The count of cash and other negotiable assets should
be coordinated with the inspection of securities.
5. Salvador Corporation
A. Instructions to be given to the assistant regarding the examination of the securities
kept in the safe deposit box include the following:

(1) A copy of the client’s record of the contents of the box should be obtained and used in
connection with the inspection of the securities. Comparing the contents of the box and the
record will provide assurance that all securities listed in the record are on hand. (The validity of
the record will be determined by examination of the transactions pertaining to investments.)
The copy of the record, after being verified, should be added to the auditors’ working papers as
evidence of work performed.

(2) The bank’s record of persons entering the deposit box should be examined to determine that
only authorized persons have had access to the box and that there was no entry to the box
between December 31 and January 11. Entry to the box between those dates may be an
indication that a security was returned to safekeeping after being “borrowed” at year-end. The
security may have been “borrowed” and used as collateral to obtain cash to cover a shortage at
December 31.
(3) The assistant should be instructed to insist that the treasurer be present while the securities
are being examined. Most auditors prefer to obtain a signed statement that all investments
inspected were returned at the completion of the inspection made in the presence of the
custodian. In any event, the working papers should note the date of the inspection and the
name of the witness to the inspection.

(4) The following details of the securities should be examined:

- The name of the registered owner appearing on each security other than bearer bonds should
be noted to determine that Pink Corporation is a registered owner and that securities belonging
to another owner have not been substituted.

- The name of the corporation issuing the security and the class of the security (Class A, Par
Value, 1st Preference, etc.) should be noted for assurance that a lower priced security (perhaps
somewhat similar in corporate name or a different security of the issuing corporation) has not
been substituted for a higher priced security.

- The face value of bonds and the number of shares represented by each share certificate should
be compared with the client record to determine that the entire amount of the corporation’s
holdings of each security is on hand.

- The serial numbers of the securities should be compared with those on the record and, for
those securities carried over from the prior year, compared with the serial numbers of securities
listed in the prior year’s working papers. A change in serial numbers that cannot be properly
explained may be an indication of manipulation of the securities. Verification of serial numbers
also helps establish the cost of securities sold under either the FIFO or specific identification cost
method.

- The certificates should be read to ascertain the interest rates and payment dates for bonds and
the dividend rates and payment dates, if given, for preference shares. This information may be
used later in the verification of investment revenue

- Bonds should be examined to determine maturity dates. Maturity dates are needed for
verifying the computation of the amortization of bond premiums or discounts. In addition, the
maturity dates will disclose whether any bonds on hand have matured. The presence of
matured bonds may be a sign of internal control weakness or may indicate that the bonds are in
default.

- Coupon bonds should be inspected to determine that no past-due interest coupons are
unclipped and all future interest coupons are attached. The presence of past-due coupons may
be caused by poor internal control and may indicate an understatement of interest revenue. On
the other hand, past-due coupons may indicate the interest is in default and that the principal is
uncollectible. Missing future interest coupons may be an indication of an irregularity
 - The auditors should be alert for any obvious alterations to securities or forged certificates.
Although auditors usually are not held responsible for the genuineness of the certificates, any
apparent forgeries (or exceptions noted in the foregoing audit procedures) may point out the
need for obtaining confirmations from the corporations issuing the certificates.
B. The treasurer’s entry into the safe deposit box on January 4 has violated the auditors’ control
over negotiable assets which must be inspected or counted simultaneously or kept under
control until counted to avoid the substitution of a counted asset for an uncounted asset in an
attempt to conceal a shortage. The auditors would probably apply the following additional
procedures:

(1) Reconcile bank balances at both year-end and at the date of inspecting securities
(2) Obtain a bank confirmation as of the inspection date.
(3) Examine cash journals between year-end and the inspection date for any unusual entries.
(4) Examine all investment transactions taking place between the balance sheet date and the
inspection date to verify the amount of the investment at the balance sheet date.
(5) If the client keeps a large fund of cash on hand, make a surprise count of the cash fund.
(6) Review the transactions since year-end relating to any other negotiable assets, such as notes
receivable, to determine if any substitutions have been made.
6. (a) (4) Having the securities held in safekeeping by a bank provides strong internal control
because the bank has no direct contact with the employees responsible for maintaining the
accounting record of the securities and that individual has no access to the securities. Thus the
separation of the custody of securities from the accounting function is complete.

(b) (1) The investment committee of the board of directors is not involved in the routine of
making buy and sell decisions and can therefore review the transactions objectively. On the
other hand, the chief operating officer, the controller, and the treasurer may be closely
associated on a daily basis with the financial executive responsible for the investment decisions.
7. The auditors can make an independent computation of dividends earned during the year by
reference to dividend record books published by investment advisory services when the auditor
is going to determine that all dividends applicable to investment in securities owned by the
client have been received and recorded.
8. If a security or derivative is not marketable (has no active market); management may obtain an
appraisal of fair value from a securities valuation firm (a specialist). In such cases, the auditors
should refer to AICPA AU-C 620 (PCAOB 336) which requires that they consider the professional
qualifications and reputation of the appraiser and obtain an understanding of the methods and
assumptions used. When a valuation model, such as an option-pricing model, is used, the
auditors should assess the reasonableness and appropriateness of the model and evaluate the
reasonableness of the underlying assumptions. The auditors should make sure that the model
considers all aspects of risk, such as counterparty credit risk, risk of adverse changes in market
factors, and risk of losses from legal or regulatory action. In addition, the auditors should
evaluate the relevance, completeness, and accuracy of any significant information provided to
the specialist by the client to be used in appraising the options.