Chapter PHASE II - RISK RESPONSE: AUDIT OF THE INVESTING CYCLE Expected Learning Outcomes After studying this chapter, you should be able to: 1. Enumerate and describe the steps involved in auditing the investing cycle. 2. Describe the nature and the major classes of transactions in the investing cycle. 3. Explain the process of analyzing and recording transactions in the investing cycle as well as the accounts, documents and records used. 4. Apply the risk assessment and risk response phases of the audit process, i.e., test of controls and substantive tests of transactions in the investing cycle. QBSCHAPTER 9 AUDIT OF THE INVESTING CYCLE INTRODUCTION This chapter covers the explanation of the investing cycle, the tapes of transactions in this cycle and the internal control environment and objective pertaining thereto. Consideration is then given to compliance tests of controls over transactions in the investing cycle In the audit of the investing cycle, the following activities should be undertaken: le Identify the activities and types of transactions that occur in a company’s investing cycle; ‘ Relate the internal accounting control objectives to investing activities; Determine the essential features of internal control over the above- mentioned transactions; Perform compliance tests of controls over these transactions: and After evaluating the effectiveness of internal control, perform substantive audit procedures to determine whether financial statement assertions are materially correct on accounts affected by the investing cycle. Design tests of details of account balances and analytical procedures to satisfy balance-related audit objectives, Steps 1 to 5 are discussed in this Chapter while Step no. 6 is covered in Chapters. 14, 15 and 16.Adit of the Investing Cycle _ 277 NATURE OF THE INVESTING CYCLE Basic Considerations Investing cycle includes the processes, procedures and policies for authorizing executing and recording transactions involving acquisition and disposition of investments in securities (¢.g., government securities, equity securities, corporate bonds) short-term and long-term, property and equipment, natural resources, intangible assets, non-trade loans, and investment property Investing Cycle Transactions Generally, the classes of transaction in the investing involve: 1. Acquisitions and disposals of securities, for temporary or long-term investments, corporate bonds and government securities, plant assets, naiural resources, intangible assets and other assets fall. into this category of transactions. 2. Lending to others, excluding open trade accounts with customers. PROCESSING INVESTING CYCLE TRANSACTIONS Figure 9-1 shows the flow of the entries in the accounts affected by the transactions in the investing cyclequawidinb3 jo ajeg Woy spaac0ig, JUSWI|SAAU| JO Jeg WON} spaad0ig juawdinb3 40 uonisinboy ;SNJUNDAS Ul JUBW}SAAU JO UO}ISINDoW 3jqiGuezul jo uonIsinboy sour|eg Guiwuibag sjesodsia | suonIppy SOUNDS Ul JUSWSOAU quawuiedwy uonezmowy PY souejeg Bujuuibeg $9qiBUE}U souejeg BuIpua 340-0. $807 quawajedwy] eourjeg Bulpu3, souejeg Buipuz souejeg Suipu3, Tesodsig uo $s07 40 ued eourjeg Buipuz | Coe uoneroaidag | aouejeg Buruuibeg sjesodsiq uonejseideg payejnunooy apd Sunsaauy ap Aq payoaysy (JenavA) sunosay Jo dyysuonepaasayuy 21-6 andi, 6 4aidoy 817DOCUMENTS AND RECORDS The pertinent documents and re are also used in the investin encountered: cords used | in the Expenditure Cycle (Chapter 7) g cycle, In addition, the following forms may also be Share Certificate. An engraved form showing the number of shares of shares owned by a shareholder in a corporation. Bond Certificate. An engraved form showing the number of bonds owned by a bondholder. Broker's Advice. A statement from a broker specifying the details of an investing transaction. Commercial Papers. Documents evidencing placements in the money market, ete. Promissory Notes. Documents evidencing non-trading loans given to the enterprise.280 Chapter 9 — AUDITING THE INVESTING CYCLE HAS — RISK ASSESSMI PERFORMING RISK ASSESSMENT PROCEDURES FOR LONG-LIVED ASSETS AFFECTED BY THE INVESTING CYCL As part of performing risk assessment procedures, — the auditor obtai ns information that is useful in assessing the risk of material misstatement. This includes information about inherent risks at the financial statement level (for example, the client’s business and operational risks and financial reporting risks) and at the account and assertion levels, fraud risks including feedback from audit team brainstorming sessions, strengths and weaknesses in internal control, and results from preliminary analytical procedures. Once the risks of material misstatement have been identified, the auditor then determines how best to respond to them as part of the audit opinion formulation process. Identifying Inherent Risks Associated with Property and Equipment Much of the inherent risk associated with long-lived assets is due to the importance of management estimates, such as estimating useful lives and residual values and determining whether asset impairment has occurred. Inherent risk related to asset impairment stems from the following factors: * Normally, management is not interested in identifying and writing down assets. * Sometimes, management wants to write down every potentially impaired asset to a minimum realizable value (although this will cause one-time reduction to current earnings, it will lead to higher reported earnings in the future). Determining asset impairment requires a good information system, @ systematic process, effective controls, and professional judgment. Other inherent risks associated with long-lived assets and related expenses include: + Incomplete recording of asset disposal e Obsolescence of assets © — Incorrect recording of assets, d A : » due to complex, ownership structures Amortization of depreciation sche impairment or use of the asset.Audit of the Investing Cycle 281 The auditor will become aware Of these risks through: * Knowledge of the client's pre; technological advancas * bis * Review of various documents, © The business plan form 1 company conducts its bu: © Major contracts regardi other companies © The minutes of board © Company fi strategies including industry trends and , including: Major acquisitions or changes in the way the isiness ng capital investments or joint ventures with rd of directors’ meetings lings with the SEC describing company action, risks, and Inherent Risks Associated with Natural Resources Natural resources present unique risks. First, it is often difficult to identify the costs associated with discovery of the natural resource. Second, once the natural resource has been discovered, it is often difficult to estimate the amount of commercially available resources to be used in determining a depletion rate. Third, the client may be responsible for restoring the property to its original condition (reclamation) after the resources are removed. Reclamation costs may be difficult to estimate. Inherent Risks Associated with Intangible Assets Intangible assets should be recorded at cost. However, the determination of cost for intangible assets is not as straightforward as it is for tangible assets, such as equipment Identifying Fraud Risk Factors niques used to fraudulently misstate financial fement of assets through overvaluing existing lizing expenses. One of the more common tech statements involves the overstat assets, including fictitious assets, or capttal ived assets include: Other potential fraud schemes relating to lon} ecorded, and proceeds are misappropriated. id are not removed from the books. lives are assigned to the assets, resulting * Sales of assets are not r Assets that have been sol * Inappropriate residual values oF in miscalculation of depreciation.282 Chapter9 Amortization of intangible assets is miscaleulated capitalized, Costs that should have been expensed are improp: 5 ‘ cognized. Impairment losses on long-lived assets are re ee able Fair value estimates are unreasonable or unsupP 7 eeee Identifying Control Risks Once the auditor has obtained an understanding of the inherent and fraud risks of material misstatement related to long-lived assets, the auditor needs to understand the controls that the client has designed and implemented to address those risks. In an integrated audit, the auditor uses this understanding to identify important controls that need to be tested. . Typical controls that effect multiple assertions for long-lived assets include: Formal budgeting process with appropriate follow-up variance analysis Written policies for acquisition and disposals of long-lived assets, including required approvals Limited physical assess to assets, where appropriate Periodic comparison of physical assets to subsidiary records Periodic reconciliations of subsidiary records with the general ledger Controls Related to Existence / Occurrence and Valuation for Tangible Assets To provide reasonable assurance that the existence and valuation assertions for fixed assets are materially correct, controls should be in place to: © Identify existing assets, inventory them, and asset inventory with the property (existence) ¢ Provide reasonable assurance t properly valued (valuation) © Appropriately classify new e and estimate of useful life (v © Periodically reassess the a (valuation) reconcile the physical ledger on a periodic basis hat all purchases are authorized and ‘quipment according to its expected use aluation) Ppropriateness of depreciation categories—____ Audit of the investing Cvcl © Identify obsolete dow _ to scrap value (valuation) eview management il in Strategy 5 impairment of assets (valuation) nt ‘YStematically assess the Many organizati condition mmaintemna @ challenge in tracking the location, quantity, approach to dealing wah Sepreciaton status of their fixed assets. One h his challenge i | often with bar codes. Th lenge is to use serial numbered asset tags, ‘ilizii en periodicall ii utilizing a barcode include: ly, the organization takes inventory, Given the challenges related to asset impairment, the auditor needs to understand management’s controls related to asset impairment judgments. Such controls should include: * A systematic process to identify assets that are not currently in use * Projections of future cash flows, by reporting unit, that is based on management’ strategic plans and economic conditions Systematic development of current market values of si prepared by the client ilar assets Controls over Natural Resources Most established natural resource companies have developed procedures and associated internal controls for identifying costs, and such organizations use geologists to establish an estimate of the reserves contained in a new discovery, These organizations periodically reassess the amount of reserves as more information becomes available during the course of mining. harvesting, or extracting resources. Controls Related to Valuation and Presentation / Disclosure for Intangible Assets For intangible assets, control should be designed to: hat decisions are appropriately made assurance _ expense research and development talize oF © tion and disclosure) 7 " rules that reflect the remaining useful life ciated with the asset (valuation) bble-asset impairments (valuation) «Provide reasonable a: as to when to cavi i a expenditures (presen ° bevelop amortization sched of patents or copyrights asso after developing independes . Ratio of depreciation expense to total depreciable Jong-lived tangible assets ~ This ratio should be predictable and comparable 's a change in depreciation method, basis, unexpected deviation any changes are reasonable. ° Ratio of repairs and maintenance ted lanaibl aseu ~ This ratio may fluctuate because of changes i? postponed without ina oor CX@™ple, maintenance expenses can be The auditor oat, neiate breakdowns or loss of productivity): this consideration in mind." '"Y% MY unexpected deviation Wl in mind, Pe expense total depreciable long-Audit of the Investing Cycle _ 285 If prelimi . reintotahna analytical procedures do not identify any unexpected risk of material uditor would conclude that there is not a heightened unexpected relat misstatements in these accounts. If unusual or conttols, subst a MiPs exist, the planned audit procedures (tests of "s+ Substantive procedures) would be adjusted to address the potential material misstatements. PHASE Il — RISK RESPONSE RESPONDING TO IDENTIFIED RISKS OF MATERIAL MISSTATEMENT Basic Considerations Once the auditor has developed an understanding of the risks of material misstatement, the auditor can determine the appropriate audit procedures to perform. Audit procedures should be proportional to the assessed risks, with areas of higher risk receiving more audit attention and effort. Responding to identified risks typically involves developing an audit approach that contains substantive procedures (such as tests of details and, when appropriate, substantive analytical procedures) and tests of controls, when applicable. esting cycle transactions and balances can generally be kept at a very low level because in most commercial enterprises (1) these transactions occur infrequently and (2) effectively controls can be maintained at relatively litle cost, Furthermore, the auditor can obtain evidential matter from independent sources outside the enterprise and acquire direct personal knowledge concerning, the balances. Audit risk for inv: This section covers 1 Evaluation and Obtaining ‘of Evidence About Internal Control : Effectiveness in the Investing Cycle Transactions I. Test of Controls and Substantive Tests of Transactions IIL. Illustrative Audit Program for the Test of Controls and Substantive . ust ( Tests of Transactions286 Chapter 9 About Internal Contro} 1. Evaluation and Obtaining Evidence Abo Effectiveness in the Investing Cycle Transactions The three operative objectives of internal accounting control are applicable to the investing cycle. These objectives consist of proper 1) Executing of transactions 2) Recording of transactions 3) Custody of assets. The specific control objectives for each function in this cycle are as follows: Existence or Occurrence / Rights and Obligations: Investing cycle transactions (i.e., purchasing, selling of securities, and receipt of periodic revenue) actually occurred. 1) Purchases of property and equipment, securities and intangibles are made in accordance with management's authorizations. 2) Sales of property and equipment, securities and intangibles are made in accordance with management's authorizations. 3) Dividend and interest checks from investments are promptly deposited intact. 4) Access to property and equipment, securities and intangibles are restricted to authorized personnel. 5) Recorded balances are compared with existing assets at reasonable intervals. Valuation / Completeness / Classification: Investing, cycle transactions ae properly recorded. 1) Transactions and events are correctly sactio s recorded as to amount, classification, and accounting period, 2) Transactions are promptly and correctl 'Y Posted indi investment accounts. Posted to individual invAudit of the Investing Cycle _ 287 Internal control over investmants The basic ii a i ic internal control practices relevant to investments are a) Purchase: eS » " S and sales should be made only on proper authorization. ) Access to securities should not be vested in one person only. c) Custodianship of inve iti di stment securities it securities should be separated. and Ge secumg (or te d) Securities must be physically controlled in order to prevent unauthorized usage and they must be registered in the name of the owner. e) Revenues received from investments periodically should be reconciled with the amounts that should be received. The following illustrates the typical errors and fraud that the auditors might identify and assess in the audit of financial investments. Internal Control Weaknesses or Factors Description of That Increase the Risk Examples of Fraud / Possible Errors or of the Misstatement Error Misstatement _ 1. Inadequate 1. Failure to record 1. Misstatement of accounting manual; changes in market recorded value of incompetent values of investments. accounting investments. personnel. _ 2. Ineffective board of | 2. Misstatement of the | 2. Misstatement of directors, audit value of closely held recorded value of committee, or investment. investments. internal audit 3. Recording fictitious function; top securities. management action not conducive to ethical conduct, undue pressure t0 meet earings targets.288 SS —. Chapter 9 - 3. Inadequate 3. An employee ih 3 pacar segregation of duties acce: a of record keeping for converts them for transactions. and custody of personal use. securities. _ ra. Inadequate -—~=«4._Failure to record Incomes . accounting manual, derivative invest 1g incompetent agreements which investment accounting are embedded in personnel; other agreements. inadequate monitoring by | internal auditors. Internal control over property and equipment The following are considered good internal control measures over property and equipment a) Additions and dispositions of property and equipment should be properly authorized and approved by the board of directors or executive committee or person to whom authority has been delegated. b) A clearly defined and sound policy for differentiation of capital and revenue expenditures should be established. ©) Cost of constructed fixed assets should be controlled through work orders d) Property and equipment controlling account sh detailed plant records, ® nt should be supported Dy e) Physical inspection of property and equip discrepancies investigated. “seipment should be conducted and f) Periodic review of adequacy of in: assets should be performed, ‘surance for fire, theft, etc. on fixed Reasonable depreciation applied. h) Fully depreciated assets still in use should i) Small tools should be locations. 8) Policy should be established and consistently be properly classified. Properly safeguarded and kept in specificAudit of the Investing Cycle _ 289 The following i might ident enc rates the typical errors and fraud that the auditors ry assess in the audit of property, plant and equipment. Internal Control ~ - _ Weaknesses or Factors That Increasi . the Risk ofthe Description of Misstatement Possible Errors or 7 Examples of Fraud/Error_| __Misstatement Undue pressure to |.1. Expenditures for repairs | 1. Misstatement of meet eamings and maintenance acquisitions of target. expenses recorded as property, plant | property, plant and and equipment. equipment acquisitions to overstate income. 2. Inadequate 2. Purchases of equipment | 2. Misstatement of accounting manual; | erroneously reported in acquisitions of incompetent | maintenance and repairs property, plant accounting | expense account. and equipment. personnel. | 3. Inadequate 3, Anassetthathasbeen | 3. Failure to record accounting policies, replaced is discarded retirements of eg., failure to use due to its lack of value, property, plant retirement work without an accounting and equipment. orders. _ entry. - 4, Inadequate 4 A‘gain" recorded onan | 4. Improper accounting manual; | exchange of reporting of incompetent nonmonetary assets that unusual accounting lacks commercial transactions. personnel. substance, Internal control aver imangible assets additions, amortization and write-offs of intangibles a) Acquisitions, j aed erly authorized. / b) sro es and y onsistency of accounting policies governing intanible assets should be reviewed periodically. c) General ledger account should be supported Py adequate detailed . hhould be periodically reconciled. : ° Sched prepared periodically and reviewed by a responsible shou! official.290 Chapter9 {Transactions IL. Tests Of Controls And Substantive Tests O . i ed tangible as Because the number of transactions that involve fix ig! SSets, securities and intangibles is usually relatively sm ane ait met controls in this area is rather limited. ; i transactions, the auditor may decide to proceed directly to substantive tests of property and equipment and investment balances after a a H ry review of the flow of transactions through the accounting system. This decision may be based on cost-benefit considerations, rather than on the absence of effective controls. When a client has an extensive investment portfolio and numerous transactions, the auditor may decide to complete his review of internal control and perform compliance tests on the controls expected to be relied on. The auditor's assessment of control risk would also be influenced by the results of tests of transactions for the expenditure and cash disbursements cycle. IIL Illustrative Audit Program for the Test of Controls and Substantive Tests of Transactions The following are procedures typically performed by auditors to determine that adequate internal control exists over property and equipment, securities and intangibles and the related expenses and revenue from these investments: 1. Trace transactions for purchases and sales of property and equipment, securities and intangibles through the system. Selected transactions for purchase or sale of property and equipment, securities and intangibles will be traced through the system to verify that the controls are being followed in actual practice. For example, @ purchase of securities should be approved in minutes of the meetings of the investment committee, and documents from the share brokerage firm should show receipt of the order and its execution, Other evidence will be the broker's month-end statement, the share certificate acquired, the entry inthe subsidiary edger for securities and the monthly report ofthe treasurer showing all purchases, surer_ show ses, sales, i ue received from investments, Siient holdings and revea- ~ Audit of the Investing Cycle _ 291 Review reports by in . voperty om ‘ by internal auditors, on their periodic inspections to property and equipment, securities and intangibles. In large companies, the intemal auditors may make inspection of Property and equipment, and securities. The independent auditor may reconcile the listing of property and equipment, securities at a given date as prepared by the internal auditors with the subsidiary ledger for securities and with the CPA firm's own working papers from the preceding years' audit. Review monthly reports by officer of client company on securities owned, purchased, and sold, and revenue earned. In many companies, the treasurer will submit to the investment committee of the board of directors a monthly report showing securities owned at the beginning of the month, all purchases, sales, gains and losses during the month the dividends and interest received and month- end holdings. Review significant changes in the composition of property and equipment and related liens and mortgages. Review rental revenue from land, buildings, and equipment owned by the client but leased to others ‘The auditors should determine that the client is applying the appropriate pending on whether the lease terms indicate a or operating lease. When the lease involves 5 must carefully evaluate when the variable accounting standards de| sales-type, direct financing, variable payments, the auditor: payments should be recognized. Examine lease agreements on properly, plant, and equipment leased to and from others. The auditors should carefully examine lease agreements to determine whether the accounting for the assets involved is proper. For example the widiters should be alert for the client's possible use of improper accounting techniques, such as the following: © Assets under a lease that are being improperly accounted for (e.g., failure to record asset and liability. for leases with terms of more than 12 months). © Leasehold improvements depreciated over the estimat to buildings under leases that are being ted useful life of the improvements rather292 Chapter 9 than the shorter term of the lease, when renewal of the lease is not reasonably assured. ; © Improper accounting for items such as initial costs, lease incentives, and variable payments. If the client has a large number of lease agreements, the auditors may use software to identify lease provisions that may affect accounting or disclosure related to the agreements.