Efficient Test of Balances Series—No. 18: A Key to Auditing Investments

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For most small to medium-size entities, internal controls over investments will usually be few in number. On the other hand, limiting the authority for making purchases and sales of investment securities, for business combinations and other investment acquisitions to those individuals charged with governance can create entity-level (key) controls that reduce the risk of material misstatement. Without such controls, the assessed level of risk of material misstatement will ordinarily be high.
 
The focus of this blog is on understanding the accounting and auditing standards that affect auditing procedures for investment securities and other investments. The auditor’s knowledge of the applicable standards is a major key to managing detection risk in this audit area.
 
Accounting Standards
 
Generally accepted accounting principles in the United States for investments are primarily included in these pronouncements:
 
  • ARB No. 51, ( FASB ASC 810): Consolidated Financial Statements
  • APB Opinion No. 18 (FASB ASC 323-10; 325-20): The Equity Method of Accounting for Investments in Common Stock
  • SFAS No. 115 (FASB ASC 320-10; 942-320): Accounting for Certain Investments in Debt and Equity Securities
  • SFAS No. 141 (R) (FASB ASC 805): Business Combinations
  • SFAS No. 157 (FASB ASC 820-10): Fair Value Measurements
  • SFAS No. 159 (FASB ASC 825-10): The Fair Value Option for Financial Assets and Financial Liabilities
  • SFAS No. 160 (FASB ASC 810): Noncontrolling Interests in Consolidated Financial Statements
  • FIN No. 46 (R) (FASB ASC 810): Consolidation of Variable Interest Entities
  • SFAS No. 167 (FASB ASC 810): Amendments to FIN 46 (R)
 
Beyond simply completing a detailed disclosure checklist, it is every auditor’s responsibility to understand the contents of the individual references to the AICPA Professional Standards in those checklists. Because of the enormous volume of requirements in the Financial Accounting Standards Board’s Accounting Standards Codification, some auditors rely on the sufficiency of disclosure checklists to determine financial statements presentations and necessary disclosures. Many auditors have learned that without an in-depth knowledge of the accounting standards, however, presentation and disclosure errors and omissions can still occur.
 
Auditing Standard
 
The principal auditing standard specifically applicable to investments is in AU Section 328, www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00328.pdf , Auditing Fair Value Measurements and Disclosures. Some of the key issues in AU Section 328 include:
 
  • For certain assets and liabilities, fair value measurements may be fairly simple. Determining fair values for investments, for example, that are bought and sold in active markets that provide readily available and reliable information on exchange prices will be fairly simple. Published exchange prices in an active market are level one inputs.
  • The auditor is required to obtain an understanding of the entity’s process for determining fair values and disclosures, as well as related internal controls to use in the design of an effective audit strategy.
  • While this section contains a detailed list of considerations the auditor may use to gain an understanding of the entity’s fair value determination process, most small to medium-size entities rarely have effective, documented controls over this process. When persons charged with governance or others have such control, their procedures should be documented and used in determining the extent of yearend tests of balances. Otherwise, risk of material misstatement will be high and the testing of the valuation will be extensive.
  • If management is unable to determine the fair value of investments, an outside specialist should be engaged to perform the work. Should the auditor be required to perform the work, to avoid impairment of the auditor’s independence the entity would be required to provide a person with suitable skill, knowledge and experience to oversee and approve the process and its results.
  • The auditor’s review of subsequent events may reveal events or circumstances that bear on valuations of investments at the engagement date. The sale of a security, for example may reveal fair value different than recorded amounts. This would be a Type I subsequent event that, if material, should result in an adjustment of the engagement date values.
  • When investments valued a fair values are significant, management’s representations about the appropriateness of measurement methods and disclosures, their consistency, completeness and adequacy should be included in the representation letter.
 
My webcast and self-study courses in the Basic Staff Training Series provide more information about auditing investments and other financial statement classifications. Your can download syllabuses and register by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com.
 
 

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