Chapter 10

1. Chapter 10 Finance and Investment Cycle “Credit has done a thousand times more to enrich mankind than all the goldmines in the world. It has exalted labor, stimulated manufacture and pushed commerce over every sea.” --Daniel Webster ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Presentation Outline • Overview of Finance and Investing Cycle • Audit of Liabilities and Stockholders’ Equity • Audit of Investments ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

3. I. Overview of Finance and Investing Cycle • Investing and Financing Cycle Activities • Inherent Risks • Investment and Finance Activities • Control Considerations • Finance and Investment Cycle: Control Procedures • Control Over Accounting Estimates ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

4. A. Investing and Financing Cycle Activities • Concerned with transactions related to the use of the organization's funds (investing) and sources of those funds (financing) other than operations. • Accounts affected by investing and financial cycle transactions include investments in securities; property, plant and equipment; notes and bonds payable; and, stockholders' equity accounts. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

5. B. Inherent Risks • Lease Accounting – circumventing capital lease rules to remove debt from balance sheet. • Loan covenants – intentional misstatement to avoid having banks call loans. • Related party transactions – more risk because they are not at arms-length. • Complex transactions – transactions are often structured to get around GAAP. Makes them difficult and hard to audit. • Impairments – taking a big bath in bad years for investments to create reserves to reduce expenses in the future. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

6. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

7. C. Investment and Finance Activities • Financial Planning – cash flow planning and capital budgeting serve as controls. • Raise capital – signature approval of high-ranking officers and consent of board of directors. Registrars and transfer agents (p. 364) • Operate business (all other cycles) – all cycles interact with finance and investment cycle. • Mergers and acquisitions – involve sources and uses of funds. • Invest excess funds – earning a short-term return on excess cash. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

8. D. Control Considerations • Transactions authorized by BOARD OF DIRECTORS • Documentation: • Investments in securities: BROKER'S ADVICE • Property, plant and equipment: VENDOR'S INVOICE (for purchased PPE) or INTERNAL COST RECORDS (for manufactured PPE) • Bonds and notes payable: Documentation from DEBTHOLDERS • Stockholders' Equity: Documentation from REGISTRAR • CASH RECEIPTS/DISBURSEMENTS JOURNALS ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

9. E. Finance and Investment Cycle:Control Procedures • Physical Controls • Securities numbered and in the client's name • Securities held by an independent custodian or in a secure location • Access to safe-deposit box requires the presence of more than one employee • Physical items periodically compared to detail records • Cash receipts from Investing and Financing cycle transactions deposited intact and daily • Segregation of Duties • Transactions AUTHORIZED by the Board of Directors • General Accounting RECORDS transactions • A separate function or external custodian has CUSTODY • Performance Reviews • Compare current investing and cycle transaction data against prior-year data or expected data • Compare revenue and expenses against organization standards or expectations. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

10. F. Control Over Accounting Estimates A sample of accounting estimates are provided on the top of p. 368. Specific aspects of estimate development an auditor considers include: • Management emphasis on proper estimation • Accumulation of sufficient relevant data from reliable sources • Qualified personnel prepare estimates • Review and approval at appropriate levels of authority • Comparison of prior estimates to results to evaluate reliability of estimate approach. • Determine if estimates are consistent with current company plans and operations. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

11. II. Audit of Liabilities and Stockholders’ Equity • Substantive Testing for Interest-Bearing Liabilities • Audit Documentation – Exhibit 10.4 • General Audit Concerns for Stockholders’ Equity • Auditing Paid-in Capital • Auditing Retained Earnings ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

12. A. Substantive Testing for Interest-Bearing Liabilities • Agree to BEGINNING BALANCE and CONFIRM with holders or makers. • LOAN PROCEEDS • VOUCH to cash receipts • Recalculate Discount/Premium • Examine note for interest, payment terms, collateral, debt covenants, etc. • LOAN PAYOFF • Recalculate Interest Expense • Recalculate Gain/Loss on Retirement • Verify cash disbursements ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

13. A. Substantive Testing for Interest-Bearing Liabilities (Continued) • INTEREST PAYMENTS • Recalculate Interest Expense • Search for UNRECORDED liabilities • Inquiry of management • Bank confirmations • Unusual amounts of interest expense • Large receipts of cash during the year • Ensure DEBT COVENANTS are met. • Inspect loan agreements. • Consider GOING CONCERN implications if not met. • Ensure proper presentation and disclosure. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

14. B. Audit Documentation – Exhibit 10.4 p. 371 ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

15. C. General Audit Concerns for Stockholders’ Equity • Overview of audit approach • EXTERNAL PARTIES involved in record keeping can confirm stockholders’ equity. Otherwise, items can be vouched to the certificate book stubs. • Transactions must be authorized by the BOARD OF DIRECTORS • Transactions must be consistent with the client's ARTICLES OF INCORPORATION ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

16. D. Auditing Paid-in Capital • Agree balances to prior year documentation • Examine issuances and repurchases of capital stock • Verify distribution of proceeds between CAPITAL STOCK and ADDITIONAL PAID-IN CAPITAL • Examine CASH RECEIPTS and CASH DISBURSEMENTS records • Determine that all transactions are RECORDED (TRACE from BOD minutes) • Verify that all transactions are PROPERLY AUTHORIZED ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

17. E. Auditing Retained Earnings • Agree beginning balance with prior year documentation • Verify the appropriateness of prior-period adjustment treatment • Trace net income/loss to INCOME STATEMENT • Ensure that DIVIDENDS are properly authorized by BOARD OF DIRECTORS ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

18. III. Audit of Investments • Substantive Audit Procedures for Investments • Trouble Spots in the Audit of Investments ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

19. A. Substantive Audit Procedures for Investments • Agree balances to Prior Year Documentation • Purchases of investments • VOUCH to BROKER'S ADVICE (Statement) • Examine BOARD MINUTES for authorization • Sales of investments • VOUCH to BROKER'S ADVICE, CASH RECEIPTS RECORDS, and BOARD MINUTES • Recalculate gain or loss on sale • Read minutes for sales of Investments and trace to recording ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

20. A. Substantive Audit Procedures for Investments (Continued) • Determine MARKET VALUE (SFAS 115) • Obtain 12/31 market price from Wall Street Journal or other sources • Evaluate for possible PERMANENT DECLINES • PHYSICALLY INSPECT or CONFIRM securities Verify Certificate Numbers to ensure that there were no unrecorded sales and subsequent repurchases • Made in company name • Can inspect at interim, if safe-deposit box • Verify DIVIDEND REVENUE • Examine CASH RECEIPTS records • Compare to external sources (Moody's, Standard & Poor's) • Evaluate presentation in BALANCE SHEET (short-term vs. long-term asset) ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

21. B. Trouble Spots in the Audit of Investments • Valuation of investments at cost, market, or value impairment that is other than temporary. • Propriety, effectiveness, and risk disclosure of derivative securities used as a hedges • Determination of the fair value of derivatives and securities, including valuation models and the reasonableness of key assumptions. • Determination of significant influence relationship for equity method investments. ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.

22. Summary • Accounts involving Investments, Property-Plant and Equipment, Debt, and Equity • Inherent risk for leases, loan covenants, related parties, complex transactions, and big baths • Estimate process and evaluation • Audit of liabilities and stockholders’ equity • Value of investments and amount of investment income ©2007 by the McGraw-Hill Companies, Inc. All rights reserved.