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Deloitte & Touche LLP - Form 1840S (6-11)

FORM 1840S — SUBSTANTIVE PROCEDURES GUIDE

Background
The Deloitte Audit is a risk-based approach that requires practitioners to understand the entity
in order to identify and respond to the risks of material misstatement in the financial
statements. In doing so, practitioners focus their risk-assessment process on the classes of
transactions; account balances, including transaction types within account balances; and
disclosures that are material and, thus, have a reasonable possibility of containing a
misstatement that, individually or when aggregated with others, have a material effect on the
financial statements. The determination of whether a class of transactions, account balance, and
disclosure is material is a matter of professional judgment that takes into account quantitative
and qualitative factors and is made without regard to the effectiveness of controls.

Once the material classes of transactions, account balances, and disclosures are identified,
practitioners identify and assess the risks of material misstatement at the financial statement
level and the assertion level for those classes of transactions, account balances, and disclosures.
Following the identification of risks of material misstatement, practitioners identify relevant
controls that may address the risks of material misstatement and design substantive procedures
that are responsive to the risks of material misstatement and the related assertion.

To assist engagement teams in documenting the Deloitte Audit, Form Series 18**S,
Manufacturing (Core) Risk of Material Misstatement Worksheets (the “Core ROMM
templates”) are available. Engagement teams are encouraged to use the Core ROMM templates
to address all material classes of transactions, account balances, and disclosures that are not
significant risks.

How to Use this Substantive Procedures Guide


This guide has been developed to assist engagement teams in identifying possible substantive
procedures that may be performed in response to risks of material misstatement for relevant
assertions.

The substantive procedures included in this guide are illustrative only and are intended to
provide generic substantive procedures to address risks of material misstatement for relevant
assertions. Tailoring the nature, timing, and extent of substantive procedures to respond to
significant risks of material misstatement related to an entity is appropriate and strongly
encouraged. Other guides or practice aids, such as the Auditing Management Estimates:
Exploring Leading Practices, can also be utilized by the engagement team to identify possible
substantive procedures to perform that are responsive to risks of material misstatement
identified.
Engagement teams are encouraged to leverage work performed in prior audits, including
previously tailored substantive procedures, to address the entity’s particular risks of material
misstatement.
Deloitte & Touche LLP - Form 1840S (6-11)

The possible procedures included within the guide are, in most cases, specific to an assertion
for a class of transaction, account balance, or disclosure. This organization allows practitioners
to utilize this guide to identify procedures that may be responsive to risks of material
misstatement and the relevant assertions. This guide may not include example responses that
are applicable to or effective in all circumstances. Conversely, this guide may have multiple
example responses that are applicable and effective. Auditor judgment is critical in determining
the most appropriate and effective response and to avoid duplication of procedures.

For the account balances and classes of transactions included herein, the guide contains
possible procedures organized by assertion. (Note: Possible procedures for presentation
and disclosure risks can be found in Form 18**S.20, Presentation and Disclosure
ROMM). It is often appropriate for engagement teams to combine the possible procedure
groups to address multiple assertions, depending on how the engagement teams identify
and document risks of material misstatement. For example, substantive analytical
procedures may cover multiple assertions depending on the design of the substantive
analytical procedures.

The directional testing matrix (i.e., overstatement or understatement testing) is no longer part
of the Deloitte Audit; however, effective corollary testing strategies can be utilized in response
to risks of material misstatement. For example, in order to address the completeness assertion
for sales, the guide offers a possible procedure group involving the test of details using debits
to cost of sales as the population. This possible procedure group may also be utilized in cost of
sales to address the occurrence assertion. Practitioners are encouraged to design substantive
procedures that may be utilized to address multiple assertions across multiple account
balances.

Other
Practitioners are also encouraged to refer to Form 1830S, Risk and Controls Guide. The pre-
populated risks of material misstatement and relevant control activities included within the
Core ROMM templates are derived from the "Core Risks and Controls" section of Form
1830S.

Questions concerning this guide can be directed to National Office (Audit Consultations).

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Deloitte & Touche LLP - Form 1840S (6-11)

THE DELOITTE AUDIT — GUIDE OF SUBSTANTIVE PROCEDURES

Account Balances and Classes of Transactions

CASH..............................................................................................................................................4
INVESTMENTS IN EQUITY SECURITIES THAT HAVE READILY DETERMINABLE
FAIR VALUES AND ALL INVESTMENTS IN DEBT SECURITIES (ASC 320)...................7
INVESTMENTS IN EQUITY SECURITIES RECORDED AT FAIR VALUE THAT DO
NOT HAVE READILY DETERMINABLE FAIR VALUES (ASC 820 AND 825)..................14
INVESTMENTS IN EQUITY SECURITIES ACCOUNTED FOR UNDER THE COST
METHOD (ASC 325) OR EQUITY METHOD (ASC 323).....................................................32
DERIVATIVE INSTRUMENTS AND HEDGE ACCOUNTING ON DERIVATIVE
INSTRUMENTS..........................................................................................................................41
PREPAID EXPENSES...............................................................................................................68
ACCOUNTS RECEIVABLE.......................................................................................................72
INVENTORY................................................................................................................................78
PROPERTY, PLANT, AND EQUIPMENT................................................................................85
GOODWILL AND OTHER INTANGIBLE ASSETS................................................................94
ACCOUNTS PAYABLE............................................................................................................104
ACCRUED EXPENSES...........................................................................................................108
NOTES PAYABLE AND LONG-TERM DEBT.......................................................................112
EMPLOYEE BENEFIT OBLIGATION....................................................................................115
INCOME TAXES.......................................................................................................................128
EQUITY......................................................................................................................................139
SALES........................................................................................................................................145
COST OF SALES......................................................................................................................153
STOCK-BASED COMPENSATION EXPENSE/ACCRUAL...............................................160
OPERATING EXPENSES.......................................................................................................177
INTEREST EXPENSE...................................................................................................184

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Deloitte & Touche LLP - Form 1840S (6-11)

CASH

ACCOUNT BALANCE ASSERTION — EXISTENCE AND VALUATION AND


ALLOCATION OF CASH

Possible Procedure 1 — Confirm Cash


A. Obtain the schedule of bank accounts and the reconciliation of the schedule to the general
ledger. Agree applicable amounts from the cash accounts schedule and reconciliation to the
general ledger and trace significant reconciling items, if any, to supporting documents.
B. Make an audit sample of bank accounts. Obtain reconciliations of the selected accounts to
the general ledger. For each selection, perform the following:
(1) Prepare, or have the entity prepare, standard bank confirmation requests for the
selected bank accounts. Mail the confirmation requests under our control, determine
that the requests are properly addressed (i.e., obtain audit evidence about the accuracy
and completeness of addresses provided by the entity), and request that all replies be
sent directly to our office.
(2) Send second requests for nonreplies.
(3) Compare replies to the balance-per-bank in the bank reconciliations. Agree all other
amounts reported in the replies to the general ledger or appropriate records. Prepare,
or have the entity prepare, reconciliations of exceptions. Trace reconciling items to
supporting documents.
(4) For confirmations not received, trace outstanding items listed on the bank
reconciliation to the subsequent month’s bank statement and, for those not traced,
trace to the cash disbursements records for the period prior to the balance sheet.
C. Determine if there is a system or process in place that facilitates electronic confirmation
between us and the confirmation respondent.
(1) If we plan to rely on such a system or process, assess the design and operating
effectiveness of the electronic and manual controls with respect to such process.
a. An assurance trust services report or another auditors’ report on such a process
may assist us in assessing the design and operating effectiveness of the
electronic and manual controls.
i. Such a report would usually address risks related to the reliability of the
information obtained through the confirmation process that we will use as
audit evidence including the risks that:
 The information obtained may not be from an authentic source
 A respondent may not be knowledgeable about the information to be
confirmed
 The integrity of the information may have been compromised.
ii. If the above risks are not adequately addressed in the report, perform

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Deloitte & Touche LLP - Form 1840S (6-11)

additional procedures to address such risks.


(2) National Office has approved the use of Capital Confirmation Inc. (CCI), for
electronic confirmations from banks that have designated CCI to process
confirmation requests from auditors.

Possible Procedure 2 — Perform Tests of Details on Bank Reconciliations

A. For those bank accounts selected in Possible Procedure 1B, perform the following:
(1) Make an audit sample of additive reconciling items and perform the following:
a. Examine related accounting records, subsequent or current bank statements,
bank credit advices, or other evidence, and determine that the selected items are
properly included as additive reconciling items.

Possible Procedure 3 — Test Cash on Hand


A. Make an audit sample of accounts representing cash on hand including significant imprest
and other working funds and undeposited cash receipts and perform the following:
(1) Arrange to count, or to have independent entity personnel count, the selected funds
(possibly on a surprise basis).
(2) If funds selected include significant items other than currency and coinage, make an
audit sample using such items and trace them to supporting documents (e.g.,
vouchers, receipts, undeposited checks) for indication of existence.

Possible Procedure 4 — Using Analytical Procedures or Tests of Details to


Update Existence Tests Performed at an Interim Date
A. Obtain the bank reconciliations for accounts with financial institutions as of the balance
sheet date and perform the following:
(1) Trace the balance per bank to bank statements and the balance per books to the
general ledger.
(2) Review the bank reconciliations for reconciling items. Determine that such items, if
any, are properly included in the reconciliations.
B. Perform substantive analytical procedures to test the ending account balance by developing
an expectation of change in the intervening period by performing the following:
(1) Develop an expectation of cash balances at the balance sheet date using appropriate
data such as the following:
a. Prior-period cash balances.
b. Monthly amounts of cash receipts and cash disbursements in the intervening
period from the interim testing date to the balance sheet date compared to such
monthly amounts in prior years and in the current year prior to the interim
testing date.
C. Determine threshold.

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Deloitte & Touche LLP - Form 1840S (6-11)

D. Compare the expectation to the recorded amount and identify any differences. For any
difference that is more than the threshold, obtain, quantify, and corroborate explanations for
the difference by performing further analysis or inquiry and examining supporting
documents. Explanations need to be sought for the full amount of the difference, not just
for the part that exceeds the threshold.

Or
E. Perform test of details on account balance change in the intervening period (i.e., from the
interim test date to the balance sheet date) by examining activity within the account
balance.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF CASH

Possible Procedure 1 — Review the Cash Reconciliations for Significant


Unreconciled Differences
A. Obtain cash reconciliations and agree details of the reconciliation to the general ledger.
B. Review the cash reconciliations for the existence of significant unreconciled differences
which could indicate an unrecorded debt or vendor payment or cash receipt.

ACCOUNT BALANCE ASSERTION — COMPLETENESS AND VALUATION AND


ALLOCATION OF CASH

Possible Procedure 1 — Perform Tests of Details on Bank Reconciliations


A. For those bank accounts selected in Possible Procedure 1B for the testing of the Existence
assertion of cash, perform the following:
(1) Make an audit sample of items from subsequent bank statements representing paid
checks, bank debit advices, and other items that potentially should be subtractive
items in the bank reconciliations items and perform the following:
a. Examine related accounting records, subsequent or current bank statements,
bank credit advices, or other evidence, and determine that the selected items are
properly included as subtractive reconciling items.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF CASH

Possible Procedure 1 — Testing Valuation of Cash Balances Denominated in


Foreign Currency
A. Agree the closing exchange rate(s) used to published records and test the translation
calculations.
B. Determine whether there are significant exchange controls or restrictions over the transfer
or use of cash balances and whether such restrictions are adequately disclosed.
C. Trace currency translation adjustments to the general ledger.

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Deloitte & Touche LLP - Form 1840S (6-11)

INVESTMENTS IN EQUITY SECURITIES THAT HAVE READILY DETERMINABLE


FAIR VALUES AND ALL INVESTMENTS IN DEBT SECURITIES (ASC 320)

ACCOUNT BALANCE ASSERTION — EXISTENCE OF EQUITY SECURITIES


THAT HAVE READILY DETERMINABLE FAIR VALUES AND ALL INVESTMENTS
IN DEBT SECURITIES

Possible Procedure 1 — Perform Inspection of Equity Securities That Have


Readily Determinable Fair Values and All Investments in Debt Securities
A. Obtain the trial balance(s) for equity securities that have readily determinable fair values,
and all investments in debt securities and the reconciliation(s) of the trial balance to the
general ledger.
(1) Agree applicable amounts from the trial balance(s) and reconciliation(s) to the
general ledger and trace significant reconciling items, if any, to supporting
documents.
B. Make an audit sample of equity securities that have readily determinable fair values and all
investments in debt securities physically held by the entity. For each selection, perform the
following:
(1) Physically inspect selected securities held by the entity.
(2) Agree information obtained from the inspection of securities (e.g., as to descriptions,
number of units held, registered holder) to the general ledger. Prepare, or have the
entity prepare, reconciliations of exceptions. Trace reconciling items to supporting
documents.

Possible Procedure 2 — Confirm Equity Securities That Have Readily


Determinable Fair Values and All Investments in Debt Securities
A. Obtain the trial balance(s) for equity securities that have readily determinable fair values,
and all investments in debt securities and the reconciliation(s) of the general ledger.
B. Agree applicable amounts from the trial balance(s) and reconciliation(s) to the general
ledger and trace significant reconciling items, if any, to supporting documents.
C. Make an audit sample of equity securities that have readily determinable fair values and all
investments in debt securities not physically held by the entity. For each selection, perform
the following:
(1) Prepare, or have the entity prepare, confirmation requests for the balances selected.
On the confirmation, consider including a listing of securities on a security by
security basis. Mail the confirmation requests under our control, determine that the
requests are properly addressed (i.e., obtain audit evidence about the accuracy and
completeness of addresses provided by the entity), and request that all replies be sent
directly to our office.
(2) Send second requests for nonreplies.

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Deloitte & Touche LLP - Form 1840S (6-11)

(3) Compare replies to requests (e.g., as to descriptions, number of units held, registered
holder). Prepare, or have the entity prepare, reconciliations of exceptions. Trace
reconciling items to supporting documents.
(4) Trace nonreplies to share purchase or similar agreements and other documentation
supporting the investor’s interest. Vouch relevant cash receipts and disbursements
related to purchases and sales.
Possible Procedure 3 — Test the Reconciliation of the Third-Party Custodian’s
Records to the General Ledger
A. Obtain a schedule of equity securities that have readily determinable fair values and all
investments in debt securities showing beginning balance, purchases, sales, and ending
balance.
(1) Agree the components from the third-party custodian’s records to the schedule.
B. Test the summarization of the schedule and agree balances to the general ledger. Trace
significant reconciling items, if any, to supporting documents.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


EQUITY SECURITIES THAT HAVE READILY DETERMINABLE FAIR VALUES AND
ALL INVESTMENTS IN DEBT SECURITIES

Possible Procedure 1 — Test Classification of Equity Securities That Have


Readily Determinable Fair Values and All Investments in Debt Securities
A. For each selection made to test existence of equity securities that have readily determinable
fair values and all investments in debt securities, perform the following:
(1) Determine the propriety of the security’s initial classification as held-to-maturity,
available-for-sale, or trading as well as any transfers of the security through the
testing date.
B. Document your understanding of transfers between categories of investments that occur.
(1) Make an audit sample of transfers between categories of investments. For the
selections made, perform the following:
a. Determine whether transfers of securities between categories of investments are
accounted for at fair value.
b. Obtain satisfactory explanations and corroborative evidence supporting the
transfers.

Possible Procedure 2 — Perform Procedures to Test Recorded Amortized Cost


of Held-to-Maturity Securities
A. For each selection made to test the existence of equity securities that have readily
determinable fair values and all investments in debt securities, perform the following:
(1) Agree the recorded costs of the selected securities to supporting documents (e.g.,
broker’s advice for investments purchased in the current period, or our prior-period

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working papers for investments purchased in prior periods).


(2) Recalculate any amortization of discounts and premiums recorded relating to
investments.

Possible Procedure 3 — Perform Procedures to Test Fair Value Measurements


of Trading and Available-for-Sale Securities
A. For each selection made to test the existence of equity securities that have readily
determinable fair values and all investments in debt securities, perform the following:
(1) Obtain the entity’s documentation that identifies the unit of account. Evaluate
whether the unit of account has been properly aggregated or disaggregated in
accordance with the applicable accounting pronouncement.
(2) Obtain the entity’s documentation regarding the following:
a. Identification of the exit market to sell the asset (principal or most advantageous
market).
b. Support for the level in the fair value hierarchy within which the fair value
measurement in its entirety falls.
(3) Evaluate management’s conclusions on the identified exit market as either the
principal or most advantageous market based on volume and level of activity from the
reporting entity’s perspective by performing the following:
a. Make inquiries of entity personnel with direct knowledge of the asset.
b. Inquire about similar transactions the entity entered into previously and obtain
documentation if applicable.
c. Obtain other internal or external analyses and supporting data when available
(e.g., transaction costs if they were considered in determining the most
advantageous market).
d. Where a most advantageous market is being used, evaluate the entity’s analysis
identifying the most advantageous market which also includes transaction costs.
(4) Obtain and include in the working papers evidence of the price used by the entity to
establish fair value. The entity’s source of the price may be the market itself [e.g.,
financial publications, the exchanges, the National Association of Securities Dealers
Automated Quotation System (NASDAQ), Pink Sheets LLC], or a third-party pricing
service based on market sources (e.g., Bloomberg, Reuters, IDC, JJ Kenny Drake).
(5) Independently obtain the market price. Our source for the market price may be the
same source that the entity used or a different source than that used by the entity. The
source may be the market itself [e.g., financial publications, the exchanges, the
National Association of Securities Dealers Automated Quotation System (NASDAQ),
Pink Sheets LLC] or a third-party pricing service based on market sources (e.g.,
Bloomberg, Reuters, IDC, JJ Kenny Drake) which we deem to be reputable. The
National Securities Pricing Center has experience with third-party pricing services
and may be of assistance to the audit engagement team (e.g., evaluating the
information from a third-party pricing source or assessing the reputation of a third-

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party pricing source).


(6) Estimate the fair value by multiplying the market price obtained times the quantity
held by the entity.
a. Compare our estimate of fair value to the fair value used by the entity and
evaluate differences.
b. If we independently obtained the market price from the same source used by the
entity, we expect the fair value estimate not to differ. Evaluate whether such
difference is a misstatement, considering the nature and cause of the estimate.
c. If we obtained a market price from a source different than the source used by
the entity, such market price could differ and still be reliable.
i. Determine an appropriate range and document rationale. Differences in
fair value which do not exceed the range are acceptable when using
market prices from different sources. If the difference exceeds the
tolerable range, the amount of the difference in excess of the range is a
misstatement.
(7) Based on the results of the procedures performed above, evaluate whether the fair
value measurement is appropriately identified as falling within Level 1 in the fair
value hierarchy in its entirety (i.e., calculated from a quoted price unadjusted in active
markets for an identical asset).

Possible Procedure 4 — Perform Procedures to Test Impairment of Equity


Securities That Have Readily Determinable Fair Values and All Investments in
Debt Securities
A. Obtain and test the documentation supporting the entity’s impairment assessment for all
equity securities that have readily determinable fair values and all investments in debt
securities.
(1) Utilizing a schedule comparing the recorded value and fair value of marketable
securities, determine if the entity properly identified securities that may be impaired.
Agree the schedule to the general ledger and to the fair value measurements tested in
Possible Procedure 3 for the testing of the valuation and allocation assertion.
(2) Verify that for each security for which an impairment assessment has been performed,
the entity’s impairment assessment has been made at the individual security level.
[Note: Individual security level means the level and method of aggregation used by
the reporting entity to measure realized and unrealized gains and losses on its debt
and equity securities.]

Possible Procedure 5 — Perform Procedures to Test the Determination as to


Whether the Security Has Other-Than-Temporary Impairment (OTTI)
A. For those individual securities that are determined to be impaired, obtain the
documentation of how the entity determined the decline in fair value below the amortized
cost basis was other-than-temporary.

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Deloitte & Touche LLP - Form 1840S (6-11)

(1) Hold discussions with key management officials in order to obtain an understanding
of the entity’s process for assessing securities for OTTI. Obtain an understanding of
the entity’s process and specifically perform the following:
a. Document our assessment of whether the process provides reasonable assurance
that all available relevant and reliable evidence concerning declines in fair
values below cost is identified and evaluated by responsible personnel.
b. Evaluate for reasonableness the entity’s process for determining when an OTTI
analysis is performed for individual securities (e.g., each reporting period).
c. Evaluate for reasonableness the entity’s process for determining which
individual securities require an OTTI analysis (e.g., has the entity considered
appropriate factors in determining which securities to assess for OTTI —
magnitude of unrealized loss position, duration of time in which fair value is
below cost basis).
d. Evaluate for reasonableness the entity’s process for assessing whether it is more
likely than not that the entity will be required to sell impaired debt securities
before recovery of the entire amortized cost basis (e.g., does the entity’s process
take into consideration factors that might require the entity to sell debt
securities, does the entity assess the probability that those factors may occur
during the anticipated recovery period).
e. Evaluate for reasonableness the entity’s process and significant assumptions
used in assessing whether the entity expects to recover the full amortized cost
basis for impaired debt securities.
f. Evaluate whether the entity is applying the appropriate accounting framework
(e.g., there are different accounting frameworks based on whether the security is
a debt or equity security).
(2) Determine whether the entity uses a third-party investment manager to manage its
investment portfolio. If this is the case, perform the following:
a. Obtain and read the terms of the written contract between the entity and the
third-party investment manager.
b. Evaluate the extent of the investment manager’s authority to initiate sales and
purchase transactions. For example, does the investment manager have full
execution authority, or is the investment manager required to obtain preapproval
from entity management or the entity’s investment committee?
c. In the absence of a written contract between the entity and the third-party
investment manager, consider confirming the terms of the arrangement directly
with the third-party investment manager.
d. Based on these procedures, evaluate for reasonableness the entity’s process for
considering the use of third-party investment managers when assessing OTTI.
Note that the OTTI accounting framework differs based on whether the security
subject to the arrangement with the third-party investment manager is a debt or
equity security.

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(3) Assess OTTI for those impaired securities not accounted for at fair value (e.g., debt
securities classified as held-to-maturity and recorded at amortized cost), and those
impaired securities accounted for at fair value with changes in fair value not recorded
through earnings (e.g., equity securities classified as available-for-sale).
a. Make an audit sample from the listing of impaired debt and equity securities not
accounted for at fair value and impaired debt and equity securities accounted for
at fair value with changes in fair value not recorded through earnings.
b. Test the fair value of the selected security, or agree the fair value per the entity
to valuation testing procedures performed elsewhere.
c. Agree the recorded amount for the security to the general ledger or trial balance.
d. If management has recorded an impairment for the selected security during the
reporting period, agree the impairment to the entity’s accounting records and
obtain management’s supporting documentation for the impairment and test the
impairment calculation.
e. Perform Step 4 or 5 within this Possible Procedure depending on the type of
security selected (e.g., debt or equity security).
(4) Perform the following procedures for impaired debt securities:
a. Obtain the entity’s OTTI analysis and conclude whether the entity’s analysis is
consistent with its processes.
b. Evaluate whether the entity has the intent to sell the debt security. In doing so,
inquire into the existence of any pending sales, or actual sales that have
occurred after the balance sheet date. Note: An entity has the intent to sell an
impaired debt security if it has decided to sell that security as of the reporting
date.
c. For selected debt securities for which we have concluded that the entity has the
intent to sell (and that an OTTI has occurred), verify that the impairment
amount (i.e., write-down to fair value) has been recognized in earnings.
d. If there is not a demonstrated intent to sell, obtain the entity’s analysis as to
whether it is more likely than not that the entity will be required to sell impaired
debt securities before recovery of the entire amortized cost basis. In evaluating
the entity’s analysis for reasonableness, consider whether it is more likely than
not that the entity will be required to sell debt securities before recovery of the
entire amortized cost basis.
e. For selected debt securities for which it is more likely than not that the entity
will be required to sell the debt security before recovery (and that OTTI has
occurred), verify that the impairment amount (e.g., entire write-down to fair
value) has been recognized in earnings.
f. If we conclude there is no demonstrated intent to sell and it is not more likely
than not that the entity will be required to sell the debt security before recovery
of the entire amortized cost basis, obtain the entity’s qualitative and quantitative
analysis as to whether the entity expects to recover the full amortized cost basis

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(e.g., whether a “credit loss” exists). Perform procedures to test the entity’s
analysis and conclude as to the reasonableness of the entity’s position. Our
procedures include testing the significant assumptions used in the entity’s
analysis. This is an area in which a Financial Instruments and Valuation Subject
Matter Resource may be of assistance to engagement teams.
(5) After performing Step 4.f above, and evaluating the entity’s analysis, if the entity
expects to recover the full amortized cost basis, an OTTI has not occurred. Verify that
any impairment for the debt security is not recognized in earnings.
a. After performing Step 4.f above and evaluating the entity’s analysis, if the entity
does not expect to recover the full amortized cost basis of the debt security, an
OTTI has occurred.
b. Verify that the credit component of the OTTI amount has been recorded in
earnings and the noncredit component of the OTTI amount has been recorded in
Other Comprehensive Income.
(6) Perform the following procedures for impaired equity securities:
a. Obtain the entity’s OTTI analysis and conclude whether the entity’s analysis is
consistent with its processes.
b. Evaluate for reasonableness the entity’s analysis as to whether an OTTI exists
for each selected impaired equity security by considering the entity’s intent and
ability to hold the security until full recovery.
c. If the equity security is not other-than-temporarily impaired, verify the
impairment amount (i.e., write-down to fair value) for the equity security is not
recognized in earnings.
d. If the equity security is other-than-temporarily impaired, verify the impairment
amount (i.e., write-down to fair value) for the equity security is recognized in
earnings.
(7) Evaluate sales of securities at a loss after the balance sheet date by performing the
following:
a. Inquire about and review debt and equity securities sold at a loss after the
balance sheet date. Evaluate whether securities sold at a loss after the balance
sheet date indicates an OTTI was present as of the balance sheet date.
(8) Perform a retrospective review to evaluate the entity’s past stated intent by making a
selection of sales of debt and equity securities made during the current reporting
period. Perform a retrospective review of the entity’s stated intent as of the prior
reporting period, and assess whether the intent stated in the prior year was consistent
with the subsequent action taken. If not, evaluate the reasons why and whether there
may be a possible bias on the part of management in the current reporting period
related to assertions made for debt and equity securities.

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ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF EQUITY


SECURITIES THAT HAVE READILY DETERMINABLE FAIR VALUES AND ALL
INVESTMENTS IN DEBT SECURITIES

Possible Procedure 1 — Management Inquiry


A. Inquire of management as to whether another party may have claim to the investment (i.e.,
that the investment is pledged as collateral to a loan).

Possible Procedure 2 — Review Documentation


A. Review documentation to determine if another party may have claim to recorded
investments (e.g., the entity no longer has rights to the investment as a result of the
investment being pledged as collateral to a loan). Consider reviewing the following:
(1) Information received in conjunction with Possible Procedures 1 and 2 to test the
Existence assertion.
(2) Minutes from meetings of those charged with governance.
(3) Significant new debt agreements.
(4) Covenant calculations.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF EQUITY SECURITIES


THAT HAVE READILY DETERMINABLE FAIR VALUES AND ALL INVESTMENTS
IN DEBT SECURITIES

Guidance — The procedure groups listed under the completeness assertion for Cash may
be relevant when designing procedures to address the Completeness assertion for
Investments.

Possible Procedure 1 — Confirm Equity Securities That Have Readily


Determinable Fair Values and All Investments in Debt Securities
A. For confirmations sent in Possible Procedure 2 for testing of the Existence assertion above,
rather than requesting a confirmation of a specific investment in a security, leave the
confirmation blank and request custodian or third party to confirm the equity securities
held and the number of shares held.

Possible Procedure 2 — Test the Reconciliation of the Third-Party Custodian’s


Records to the General Ledger
A. Obtain a schedule of equity securities that have readily determinable fair values and all
investments in debt securities showing beginning balance, purchases, sales, and ending
balance.
(1) Agree the components from the third-party custodian’s records to the schedule.
B. Test the summarization of the schedule and agree balances to the general ledger. Trace
significant reconciling items, if any, to supporting documents.

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Deloitte & Touche LLP - Form 1840S (6-11)

C. Make an audit sample of disposals. For each selection, perform the following:
(1) Examine the documents authorizing the disposal. Verify the disposed investment is
excluded from the listing of equity securities that have readily determinable fair
values and all investments in debt securities at the end of the period.

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Deloitte & Touche LLP - Form 1840S (6-11)

INVESTMENTS IN EQUITY SECURITIES RECORDED AT FAIR VALUE THAT DO


NOT HAVE READILY DETERMINABLE FAIR VALUES (ASC 820 AND 825)

ACCOUNT BALANCE ASSERTION — EXISTENCE OF INVESTMENTS

Possible Procedure 1 — Perform Inspection of Investments


A. Obtain the investments trial balance and the reconciliation of the investments trial balance
to the general ledger.
(1) Agree applicable amounts from the investments trial balance and reconciliation to the
general ledger and trace significant reconciling items, if any, to supporting
documents.
B. Make an audit sample of investments physically held by the entity. For each selection
perform the following:
(1) Physically inspect selected securities held by the entity.
(2) Agree information obtained from the inspection of securities (e.g., as to descriptions,
number of units held, registered holder) to the general ledger. Prepare, or have the
entity prepare, reconciliations of exceptions. Trace reconciling items to supporting
documents.

Possible Procedure 2 — Confirm Investments


A. Obtain the investments trial balance and the reconciliation of the investments trial balance
to the general ledger.
(1) Agree applicable amounts from the investments trial balance and reconciliation to the
general ledger and trace significant reconciling items, if any, to supporting
documents.
B. Make an audit sample of investments not physically held by the entity. For each selection,
perform the following:
(1) Prepare, or have the entity prepare, confirmation requests for the balances selected.
On the confirmation, consider including a listing of securities on a security-by-
security basis. Mail the confirmation requests under our control, determine that the
requests are properly addressed (i.e., obtain audit evidence about the accuracy and
completeness of addresses provided by the entity), and request that all replies be sent
directly to our office.
(2) Send second requests for nonreplies.
(3) Compare replies to requests (e.g., as to descriptions, number of units held, registered
holder). Prepare, or have the entity prepare, reconciliations of exceptions. Trace
reconciling items to supporting documents.
(4) Trace nonreplies to share purchase or similar agreements and other documentation
supporting the investor’s interest. Vouch relevant cash receipts and disbursements
related to purchases and sales.

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Deloitte & Touche LLP - Form 1840S (6-11)

Possible Procedure 3 — Confirm Investments — Direct Investments and Other


Alternative Investments1
A. Obtain the investments trial balance and the reconciliation of the investments trial balance
to the general ledger.
(1) Agree applicable amounts from the investments trial balance and reconciliation to the
general ledger and trace significant reconciling items, if any, to supporting
documents.
B. Make an audit sample of investments not physically held by the entity. For each selection,
perform the following:
(1) Prepare, or have the entity prepare, confirmation requests for the investments
selected. On the confirmation, consider including a listing of securities on a security-
by-security basis. Confirmation of investments in the aggregate (e.g., ownership
percentage of the fund or shares/units of the fund held) versus on a security-by-
security basis for investments held by the fund does not by itself constitute adequate
evidence with respect to the existence assertion. If the fund is only willing to confirm
the entity’s investment in the aggregate, perform additional procedures such as those
in Procedure C to test the existence assertion.
a. When the audited balance sheet date of the investee entity differs from the
balance sheet date of the investor entity, confirm the information above as of the
investor entity’s balance sheet date and also as of the balance sheet date of the
investee’s audited financial statements, including the capital activity for both the
period from the audited balance sheet date of the investee to the entity’s year-
end as well as for the period from the beginning of the entity’s fiscal year to the
balance sheet date of the investee’s audited financial statements. [For example,
if the entity’s year-end is June 30, 20x6, and the investee’s year-end audited
statements are as of December 31, 20x5, the confirmation would confirm
investment balances as of both December 31, 20x5, and June 30, 20x6, and
capital activity for the period July 1, 20x5, to December 31, 20x5, and from
December 31, 20x5, to June 30, 20x6.]
(2) Mail the confirmation requests under our control, determine that the requests are
properly addressed (i.e., obtain audit evidence about the accuracy and completeness
of addresses provided by the entity), and request that all replies be sent directly to our
office.
(3) Send second requests for nonreplies.
(4) Compare replies to requests (e.g., as to descriptions, number of units held, registered
holder). Prepare, or have the entity prepare, reconciliations of exceptions. Trace
reconciling items to supporting documents.
(5) Trace nonreplies to share purchase or similar agreements and other documentation
supporting the investor’s interest. Vouch relevant cash receipts and disbursements
related to purchases and sales.
C. Determine whether we have received sufficient audit evidence for the existence assertion:

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Deloitte & Touche LLP - Form 1840S (6-11)

(1) If we have received a confirmation in the aggregate and we have obtained audited
financial statements of the investee as of the entity’s year-end prepared on the same
basis of accounting, or if the confirmation was not returned but we have received
audited financial statements with individual schedules of partners’ capital, the
existence assertion is deemed to have been satisfied.
(2) If the confirmation is not returned or if the confirmation returned did not include a
detailed listing on a security-by-security basis and we did not receive audited
financial statements of the investee as of the entity’s year-end prepared on the same
basis of accounting, perform alternative procedures to test existence of the selection.
Completion of only one of the procedures noted below would ordinarily not
constitute sufficient appropriate audit evidence to test the existence assertion.
Alternative procedures may include performing a combination of the following:
a. Review executed partnership, trust, limited liability corporation, or similar
agreements.
b. Review periodic statements from the fund or trustee reflecting investment
activity and compare activity with amounts recorded by the investor.
c. Vouch relevant cash receipts and disbursements related to purchases and sales.
d. Observe or review documentation of management site visits or telephone calls
to investee funds.

ACCOUNT BALANCE ASSERTION — VALUATION OF INVESTMENTS

Possible Procedure 1 — Test Fair Value Measurements — Direct Investments,


External Pricing Sources
A. For selections of direct investments made to test existence for which the entity obtained
estimates of fair value from external pricing sources (i.e., brokers or other third-party
sources such as pricing services) based on proprietary valuation models, perform the
following:
(1) Determine whether estimates from more than one external pricing source (i.e., broker
or other third-party source) are needed to substantiate the fair value. For example,
obtaining estimates from more than one source is appropriate if either of the
following occur:
a. The external pricing source has a relationship with an entity that might impair
its objectivity, such as an affiliate or a counterparty involved in selling or
structuring the product.
b. The valuation is based on assumptions that are highly subjective or particularly
sensitive to changes in the underlying circumstances.
Note: When two sources are necessary and the client has not obtained more than one
source, our procedures need to include obtaining a second source. Consider using the
National Securities Pricing Center (NSPC) to obtain a second source.
(2) Test the entity’s evidence of fair value obtained from external pricing source(s) (i.e.,

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Deloitte & Touche LLP - Form 1840S (6-11)

brokers or other third-party sources such as pricing services) as follows:


a. Obtain the entity’s documentation of the fair value obtained from the external
pricing source(s) (e.g., broker quote(s) and/or report(s) from pricing service(s)).
b. Agree the description/identifiers of the financial instrument to evidence
previously obtained in regards to the validity of the financial instrument.
c. Evaluate whether any disclaimers or limitations on the entity’s external pricing
documentation are such that we may not rely upon it for audit purposes.
Consider consulting with a Financial Instrument and Valuation Subject Matter
Resource when external pricing documentation contains language which may
limit our ability to rely on the price quote for the purposes of our audit.
(3) Evaluate the reputation of each broker or other third-party pricing source by
performing the following:
a. Obtain and document our understanding of the reputation of the broker or other
third-party pricing source.
b. Evaluate whether the broker or other third-party pricing source is viewed as
reputable for pricing the financial instrument. The NSPC may be of assistance
to the audit engagement team.
(4) For each price quote (excluding those we received from our NSPC), confirm the
quote with the broker or other third-party pricing source by performing the following:
a. Prepare, or have the entity prepare, confirmation requests. Confirm the financial
instrument description/identifier and the price quote as of the appropriate
measurement date.
b. Mail the confirmation requests under our control, determine that the requests are
properly addressed (i.e., obtain audit evidence about the accuracy and
completeness of addresses provided by the entity), and request that all replies be
sent directly to our office.
c. Send second requests for nonreplies and request the entity to follow up, if
necessary.
d. Compare replies to the entity’s financial reporting records (e.g., as to
descriptions, number of units held, registered holder). Examine supporting
documents for any reconciling items.
e. Evaluate whether any disclaimers or limitations included in the confirmation are
such that we may not rely upon it for audit purposes. Consider consulting with a
Financial Instrument and Valuation Subject Matter Resource when the
confirmation contains language which may limit our ability to rely on it for the
purposes of our audit.
f. If replies are not received, perform alternative procedures. An example of an
alternative procedure is to agree the price quote to the pricing service with the
assistance of our NSPC if the confirmation was sent to a pricing service to
which the NSPC also subscribes.

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Deloitte & Touche LLP - Form 1840S (6-11)

(5) Understand the method and evaluate the assumptions used by the broker or other
third-party pricing source in developing the estimate.
(6) When obtaining fair value estimates from multiple third-party sources, such
understanding and evaluation is needed for at least one of the fair value estimates
obtained. Inquiries need to be made of a pricing source to understand the method
used. Because several of those questions require an understanding of financial
modeling and familiarity with appropriate market inputs, the related responses to the
inquiries may be evaluated by a professional with sufficient knowledge in these areas.
A senior and experienced Financial Instrument and Valuation Subject Matter
Resource or a professional in the NSPC generally would qualify. The working papers
need to include documentation of substantive and complete responses to the
following questions:
a. Is the pricing source independent of the entity and of the security being
measured?
b. Is the pricing source reputable and nationally recognized?
c. If a broker, does the broker trade or make a market (a broker would be
considered to make a market in a security if that broker stands ready to buy or
sell a particular security in the over-the-counter market at prices the broker-
dealer has quoted) in this particular security?
d. If a pricing service, how does the pricing service obtain prices for each type of
security?
e. Is the quote from the pricing source based on a model or recent trades?
f. If based on a model, what type of model is used to price each type of security?
g. If based on a model, what are the significant or sensitive assumptions, inputs,
and sources of inputs included in the models for each type of security?
Responses include quantitative information regarding inputs as well as
qualitative information. Ranges of quantitative information, rather than point
estimates, may be acceptable in the circumstances.
h. If based on a model, are the inputs based on available market data or are the
inputs unobservable in the market?
i. If based on a model, are the models, assumptions, and inputs the same as used
for your own books and records?
j. If based on a model, was the model subject to price validation procedures by the
pricing source?
k. Is the quoted price reflective of a market the client can access?
l. Does the pricing source express disclaimers or limitations on the use of the
quote such that the auditor may be unable or unwilling to rely on the
confirmation?
(7) Evaluate the reasonableness of the significant assumptions and document the basis for
our conclusions, considering the nature of the financial instrument and the fair value

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Deloitte & Touche LLP - Form 1840S (6-11)

financial reporting objective (i.e., the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants at the
measurement date). The NSPC or a Financial Instrument and Valuation Subject
Matter Resource may be of assistance to the audit engagement team.
(8) If, as a result of the procedure above, we have concerns about the reliability or
appropriateness of the external pricing information for financial reporting purposes,
request that the entity obtain and provide to us additional evidence and/or perform
alternative procedures to test the fair value measurement.
(9) Compare the evidence from the external pricing source(s) to the entity’s fair value
measurement used for financial reporting purposes by performing the following:
a. Agree the estimate from the evidence of the pricing source to the entity’s fair
value used for financial reporting purposes. If differences arise, investigate and
document our conclusions as to whether the differences are misstatements.
b. For financial instruments in which it was determined that estimates from more
than one external pricing source were needed to substantiate the fair value,
establish an acceptable tolerance threshold for the purposes of comparing the
multiple prices and document the basis for such threshold. When obtaining and
comparing market prices from multiple sources for the identical financial
instrument, market prices could differ or may be expected to differ based on the
nature of the financial instrument. Determining an acceptable tolerance
threshold requires judgment, and consultation with the NSPC or Financial
Instrument and Valuation Subject Matter Resource is encouraged. Differences in
fair value which do not exceed threshold are acceptable when using market
prices from different sources. If the difference exceeds the threshold, the
amount of the difference in excess of the threshold is a misstatement.
c. If the multiple prices do not vary from each other by more than the acceptable
tolerance threshold, we may conclude that the entity’s fair value measurement,
which agrees to one of the prices, is reasonable.

Possible Procedure 2 — Test Fair Value Measurements — Direct Investments, 2


Model
A. For direct investment selections made to test existence that have fair value calculated
based on a model, obtain and read the fair value analysis (model, assumptions, and
underlying data), including schedules and narrative if not already obtained.
(1) Test the mathematical accuracy of the portions of the fair value model related to the
valuation assumptions by recomputing the amounts, or by other appropriate means.
(2) Test the mathematical accuracy of the portions of the fair value model related to the
business and accounting assumptions by recomputing the amounts, or by other
appropriate means.
(3) Test the mathematical accuracy of the overall model by footing, cross-footing, and
recalculating, as appropriate.
B. Evaluate whether the valuation technique or techniques (i.e., valuation methodology) is/are

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Deloitte & Touche LLP - Form 1840S (6-11)

appropriate in the circumstances and whether the technique or techniques used for
determining fair value is/are applied consistently with the preceding periods (given
possible changes in the environment or circumstances affecting the entity or changes in
accounting principles). Consider the following, as applicable:
(1) Whether the valuation technique (i.e., method) of measurement maximizes the use of
observable inputs and minimizes the use of unobservable inputs. (Inputs refer broadly
to assumptions that market participants would use in pricing the asset or liability).
(2) Whether a single valuation technique or multiple valuation techniques is/are
appropriate in the circumstances and for which sufficient data is available.
(3) In instances where management has determined that different valuation techniques
result in a range of significantly different fair value measurements, how the entity
investigated the reasons for these differences in establishing its fair value
measurements.
(4) In circumstances where multiple valuation techniques were employed, whether the
results were evaluated and weighted appropriately to identify a single estimate within
a reasonable range that is most representative of the fair value.
(5) Whether a change in the valuation technique or its application (e.g., a change in its
weight when multiple valuation techniques are used) is appropriate if the change
results in a measurement that is equally or more representative of fair value in the
circumstances (e.g., new markets develop, new information becomes available,
information previously used is no longer available, or valuation methods improve).
a. If the item was tested in the prior period, compare to the valuation technique or
techniques used in the prior period for consistency.
(6) Whether the valuation technique is appropriate in relation to the business, industry,
and environment in which the entity operates.
(7) Whether any revisions resulting from a change in a valuation technique or its
application (e.g., a change in its weight when multiple valuation techniques are used)
are accounted for as a change in accounting estimate or error correction.
C. Assess reasonableness of the valuation assumptions (or “inputs”) used in the fair value
analysis and whether the valuation assumptions are consistent with what market
participants would use in pricing the item.
(1) Evaluate whether management used relevant information that was reasonably
available at that time.
(2) Evaluate whether management used observable inputs first (Level 1, then Level 2,
then Level 3) to the extent possible in determining the valuation assumptions
following the fair value hierarchy.
(3) Evaluate whether the entity has determined fair value using quoted prices
(unadjusted) for identical assets or liabilities in active markets except as discussed
below:
a. If the entity holds a large number of similar assets or liabilities (e.g., debt
securities) that are required to be measured at fair value, a quoted price in an

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Deloitte & Touche LLP - Form 1840S (6-11)

active market might be available but not readily accessible for each of those
assets or liabilities individually. In that case, the fair value may be measured
using an alternative pricing method that does not rely exclusively on quoted
prices (e.g., matrix pricing) as a practical expedient.
b. In some situations, a quoted price in an active market might not represent fair
value at the measurement date. That might be the case if, for example,
significant events (principal-to-principal transactions, brokered trades, or
announcements) occur after the close of a market but before the measurement
date. Evaluate whether the entity has established and consistently applied a
policy for identifying those events that might affect fair value measurements.
(4) Evaluate whether an adjustment for risk is necessary to any of the valuation
assumptions used by management. An adjustment for risk would be appropriate if the
identified market participants would include one in pricing the asset or liability.
(5) Evaluate whether the entity has reflected the nonperformance risk in measuring the
fair value of a liability, thereby considering the effect of changes in its credit risk
(credit standing) on the fair value of a liability as well as credit enhancements related
to the liability, if any.
(6) Evaluate whether the entity appropriately adjusted Level 2 inputs depending on
factors specific to the asset or liability such as:
a. Conditions of the item.
b. Location of the item.
c. Extent to which the inputs relate to items that are comparable to the asset or
liability.
d. Volume and level of activity in the markets within which inputs are observed.
(7) Evaluate whether the entity has considered whether any adjustment(s) made to a
Level 2 input are significant to the fair value measurement in its entirety, thereby
potentially rendering the measurement a Level 3 measurement, depending on the
level in the fair value hierarchy within which the inputs used to determine the
adjustment(s) fall.
(8) Evaluate whether the entity developed its Level 3 unobservable inputs in the
following manner:
a. Unobservable inputs have only been used to the extent that observable inputs
are not available.
b. In developing the inputs, the entity’s objective is an exit price from the
perspective of a market participant that holds the asset or owes the liability.
Therefore, unobservable inputs reflect the reporting entity’s own assumptions
about the assumptions that market participants would use in pricing the asset or
liability (including assumptions about risk).
c. Unobservable inputs have been developed based on the best information
available in the circumstances, which might include the reporting entity’s own
data. [Note: In developing unobservable inputs, the reporting entity need not

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Deloitte & Touche LLP - Form 1840S (6-11)

undertake all possible efforts to obtain information about market participant


assumptions.]
d. The reporting entity has not ignored information about market participant
assumptions that is reasonably available without undue cost and effort.
e. The reporting entity’s own data used to develop unobservable inputs has been
adjusted if information is reasonably available without undue cost and effort
that indicates that market participants would use different assumptions.
(9) For purposes of financial statement disclosures, identify the lowest level of any one
of the significant valuation assumptions as either:
a. Level 1 (quoted prices in an active market for identical assets or liabilities)
b. Level 2 (inputs other than quoted prices included in Level 1 that are observable
for the item either directly or indirectly)
c. Level 3 (unobservable inputs for the asset or liability).
(10) Agree information used in developing the key valuation assumptions to appropriate
supporting documentation.
(11) Consider whether the valuation assumptions, taken individually and as a whole, are
realistic and consistent with:
a. The general economic environment, the economic environment of the entity’s
specific industry, and the entity’s economic circumstances.
b. Existing market information.
c. The entity’s plans and experience, to the extent currently applicable, including
management’s expectations for the outcome of specific objectives and strategies
adjusted for any considerations market participants would make.
d. Valuation assumptions made in prior periods. Compare assumptions used in the
prior period to those used in the current period. Inquire as to material variances
between the periods.
e. Other matters relating to the financial statements (e.g., assumptions used by
management in other fair value measurements).
f. The risk associated with cash flows, including the potential variability in the
amount and timing of the cash flows and the related effect on the discount rate.
(12) If historical financial information is used in the development of valuation
assumptions, consider (1) the extent to which such reliance is reasonable in light of
any new activities or changing circumstances and (2) whether the preparer adequately
considered or made necessary adjustment that market participants would make.
(13) When management’s intent is relevant to one or more of the valuation assumptions,
evaluate the reasonableness of management’s plan.
a. Consider management’s history of carrying out its stated intentions with respect
to assets or liabilities.
b. Read written plans and other documentation, including, where applicable,

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Deloitte & Touche LLP - Form 1840S (6-11)

budgets, minutes, and other such items.


c. Consider management’s stated reasons for choosing a particular course of
action.
d. Consider management’s ability to carry out a particular course of action given
the entity’s economic circumstances, including the implications of its
contractual commitments.
e. Consider whether management’s plan is consistent with business plans,
forecasts, and other information provided to the audit committee, lenders,
analysts (if public), and others.
(14) Evaluate whether the significant valuation assumptions used in measuring fair value,
taken individually and as a whole, provide a reasonable basis for the fair value
measurements.
D. Assess the reasonableness of the business and accounting assumptions used in the fair
value analysis and whether the business and accounting assumptions are consistent with
what market participants would use in pricing the item.
(1) Evaluate whether management used relevant information that was reasonably
available at that time and reflects what market participants would use (e.g., consider
information published in equity analyst reports for public entities).
(2) Evaluate whether an adjustment for risk is necessary to any of the business and
accounting assumptions used by management. An adjustment for risk would be
appropriate if the identified market participants would include one in pricing the asset
or liability.
(3) If the item has a specified (contractual) term, evaluate whether the entity only
considered the input to be a Level 2 input if the input is observable for substantially
the full term of the asset or liability (e.g., 9 of 10 years).
(4) Evaluate whether the entity developed its Level 3, unobservable inputs in the
following manner:
a. Unobservable inputs have only been used to the extent that observable inputs
are not available.
b. In developing the inputs, the entity’s objective is an exit price from the
perspective of a market participant that holds the asset or owes the liability.
Therefore, unobservable inputs reflect the reporting entity’s own assumptions
about the assumptions that market participants would use in pricing the asset or
liability (including assumptions about risk).
c. Unobservable inputs have been developed based on the best information
available in the circumstances, which might include the reporting entity’s own
data. [Note: In developing unobservable inputs, the reporting entity need not
undertake all possible efforts to obtain information about market participant
assumptions.]
d. The reporting entity has not ignored information about market participant
assumptions that is reasonably available without undue cost and effort.

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Deloitte & Touche LLP - Form 1840S (6-11)

e. The reporting entity’s own data used to develop unobservable inputs has been
adjusted if information is reasonably available without undue cost and effort
that indicates that market participants would use different assumptions.
(5) Agree information used in developing the key business and accounting assumptions
to appropriate supporting documentation.
(6) Consider whether the business and accounting assumptions, taken individually and as
a whole, are realistic and consistent with:
a. The general economic environment, the economic environment of the specific
industry, and the entity’s economic circumstances.
b. Existing market information.
c. The entity’s plans and experience, to the extent currently applicable, including
management’s expectations for the outcome of specific objectives and strategies
adjusted for any considerations a market participant would make.
d. Business and accounting assumptions made in prior periods. Compare
assumptions used in the prior period to those used in the current period. Inquire
as to material variances between the periods.
(7) If historical financial information is used in the development of business or
accounting assumptions, consider (a) the extent to which such reliance is reasonable
in light of any new activities or changing circumstances and (b) whether the preparer
adequately considered or made necessary adjustments that market participants would
make.
(8) When management’s intent is relevant to one or more of the business or accounting
assumptions, evaluate the reasonableness of management’s plan.
a. Consider management’s history of carrying out its stated intentions with respect
to assets or liabilities.
b. Read written plans and other documentation, including, where applicable,
budgets, minutes, and other such items.
c. Consider management’s stated reasons for choosing a particular course of
action.
d. Consider management’s ability to carry out a particular course of action given
the entity’s economic circumstances, including the implications of its
contractual commitments.
(9) Evaluate whether the significant business and accounting assumptions used in
measuring fair value, taken individually and as a whole, provide a reasonable basis
for the fair value measurements in the entity’s financial statements.
E. Evaluate whether the fair value has not been adjusted for transactions costs.
F. Evaluate whether the fair value has been adjusted for transportation costs when location is
an attribute of the asset or liability (as might be the case for a commodity).
G. Evaluate whether the fair value model being used is appropriate considering the entity’s
circumstances and valuation premise (in-use or in-exchange) identified (e.g., do the

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Deloitte & Touche LLP - Form 1840S (6-11)

assumptions, methods, and circumstances all form an appropriate model).


(1) Evaluate whether an adjustment for risk is necessary to the model used by
management. An adjustment for risk would be appropriate if the identified market
participants would include one in pricing the asset or liability.
H. Test the underlying data used to develop the fair value measurement and disclosure to
determine that the information used in the analysis is accurate and complete. Such tests
might include:
(1) Agreeing the data to appropriate supporting documentation.
(2) Recomputing mathematical inputs.
(3) Reviewing data for internal consistency.
I. Consider whether a sensitivity analysis needs to be prepared, based on results of audit
procedures performed in this section, for comparison to the entity’s fair value estimate.
Ordinarily, a sensitivity analysis is prepared when we find:
(1) One or more assumption(s) (input(s)) to not be reasonable.
(2) The valuation techniques are not appropriate or multiple techniques were not used in
circumstances where they are appropriate and for which sufficient data is available.
(3) A mathematical or computational error is identified in the model.
J. Using management’s documentation or other inquiries, evaluate whether the following
items were appropriately addressed in the fair value documentation:
(1) Whether the fair value measurement of a standalone asset or liability or a group of
assets and/or liabilities considered the attributes specific to the asset or liability, for
example, the condition and/or location of the asset or liability and restrictions, if any
on the use of the asset at the measurement date.
(2) Whether the fair value has been determined assuming an orderly transaction between
market participants to sell the asset or transfer the liability at the measurement date,
such that the transaction assumes exposure to the market for a period prior to the
measurement date to allow for marketing activities that are usual and customary for
the transactions involving such assets and liabilities (i.e., it is not a forced liquidation
or distress sale).
K. If a sensitivity analysis is prepared, compare the entity’s estimate to the amount (or range
of reasonable amounts) resulting from the sensitivity analysis. Any difference between the
entity’s estimate and the closest reasonable estimate is a misstatement.

Possible Procedure 3 — Test Fair Value Measurements — Direct Investments,


Independent Estimate
A. For direct investment selections made to test existence, develop an independent fair value
estimate to corroborate the entity’s fair value measurement by performing the following:
(1) Develop an independent point estimate or range of the fair value of the financial
instrument by performing the following (consider using the assistance of the NSPC or
a Financial Instrument and Valuation Subject Matter Resource):

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Deloitte & Touche LLP - Form 1840S (6-11)

a. Understand and document the significant assumptions used by management in


developing its fair value estimate.
b. To develop our independent point estimate or range, either use management’s
assumptions or develop our own separate assumptions (i.e., inputs) by
considering the following:
i. If we decide to use management’s assumptions, evaluate whether the
assumptions used by management are reasonable.
ii. When developing our own separate assumptions, use our understanding of
management’s assumptions to determine that our model considers the
significant variables and evaluate any significant differences from
management’s estimate.
iii. In selecting assumptions, maximize the use of observable inputs and
minimize the use of unobservable inputs. Observable inputs reflect the
assumptions market participants would use in pricing the asset or liability
developed based on market data obtained from sources independent of the
reporting entity.
c. Identify a valuation technique which is appropriate in the circumstances to use
in developing the independent point estimate or range by considering the
following:
i. In certain circumstances, a commercial financial model from a reputable
source (e.g., available from electronic information vendors or licensed
from software vendors) may be appropriate.
ii. In certain circumstances, it may be necessary to develop our own financial
model.
iii. We may use management’s model, if we have evaluated the model and
found it to be appropriate.
d. Identify and use other data necessary for the model, considering the following:
i. Use the most appropriate data available.
ii. Only use management’s data if we have determined that the data is
accurate, complete, and relevant and that the fair value measurements
have been properly determined using such data and management’s
assumptions.
iii. When using market data, determine that the market data used is accurate,
complete, relevant, current as of the date of the valuation, and appropriate
for use in the valuation model selected.
e. Determine whether our selected technique, assumptions, and other data are
appropriate for estimating the fair value (i.e., the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date).
f. Calculate our independent point estimate or range of fair value using the

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Deloitte & Touche LLP - Form 1840S (6-11)

selected technique, assumptions, and other data.


(2) Compare the recorded amount(s) to our point estimate or range and evaluate any
differences. When a point estimate has been developed, the difference between our
point estimate and the recorded estimate constitutes a misstatement. When a range
provides sufficient appropriate audit evidence and the recorded estimate lies outside
the range, the misstatement is no less than the difference between the recorded
amount and the nearest point in the range.

Possible Procedure 4 — Test Fair Value Measurements — Direct Investments,


Subsequent or Recent Transactions
A. For direct investment selections made to test existence, compare the fair value
measurement to relevant subsequent or recent transactions by performing the following:
(1) When using a subsequent or recent event or transaction to substantiate a fair value
measurement, we consider only those events or transactions that reflect circumstances
existing at the balance sheet date. Accordingly, if a market transaction involving an
identical financial instrument occurring near the balance sheet date has been
identified, consider whether the facts and circumstances of the transaction are such
that the transaction value is a relevant reference for the entity’s fair value
measurement at the balance sheet date.
a. Evaluate whether the event or transaction is reflective of the price that would be
received to sell an asset or paid to transfer a liability in an orderly (i.e.,
nondistressed) transaction between market participants at the measurement date.
b. For an event or transaction occurring after the balance sheet date, evaluate if the
event or transaction reflects changes in circumstances occurring after the
balance sheet date and thus does not represent relevant and reliable evidence of
the fair value measurement at the balance sheet date.
c. For an event or transaction occurring before the balance sheet date, evaluate if
circumstances have changed from the transaction date to the balance sheet date
such that the event or transaction does not represent relevant and reliable
evidence of the fair value measurement at the balance sheet date.
(2) If we conclude that an event or transaction near the balance sheet date is
representative of the fair value measurement at the balance sheet date, compare the
amount to the fair value measurement at the balance sheet date.
Possible Procedure 5 — Test Fair Value Measurements — Alternative
Investments, Audited Financial Statements 3

A. For those alternative investments selected to test existence which have annual audits
performed on their financial statements, obtain the most recent audited financial statements
and the accompanying auditors’ report.
(1) Obtain and test the entity’s reconciliation of its recorded investment as of the date
which corresponds with the balance sheet date of the audited financial statements of
the investee. Investigate, evaluate, and document whether reconciling items are
misstatements. If the investor entity’s basis of accounting is different from the

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Deloitte & Touche LLP - Form 1840S (6-11)

investee, obtain and test the reconciliation between the methods of accounting used.
(2) Reconcile the entity’s recorded investment at the investor entity’s year-end and also at
the balance sheet date of the audited financial statements of the investment, if
different, to the confirmation amounts. Investigate, evaluate, and document whether
differences are misstatements.
(3) Evaluate the audited financial statements obtained in the procedure above and
conclude whether anything noted within the financial statements or the auditors’
report has an impact on our risk assessment or our ability to rely on the audited
financial statements as audit evidence. Consider the following items when evaluating
the financial statements:
 Qualifications and reputation of the audit firm
 Nature of the auditors’ report (e.g., qualified or adverse, whether there is an
emphasis of a matter paragraph), and any other unusual characteristics which may
increase professional skepticism as to the validity of the audit report or financial
statements (e.g., missing city or letterhead on opinion, poorly worded opinion)
 Accounting principles used and the valuation policy of the underlying investments
 Illiquid or unusual investments
 Potential material loss contingencies
 Whether a concentration exists in particular securities
 Whether other relevant disclosure items are present (e.g., significant related
parties).
(4) Conclude that we have sufficient evidence regarding the valuation if we have (1)
confirmed the investment at the investor’s balance sheet date, (2) audited the
reconciliation of the investor entity’s investment as of the balance sheet date to
audited financial statements of the investee as of the same balance sheet date, and (3)
evaluated the audited financial statements of the investment noting no significant
concern about their relevance and reliability.

Possible Procedure 6 — Test Fair Value Measurements — Alternative


Investments, Underlying Investments
A. For alternative investment selections made to test existence where the investor entity’s
management is able to obtain details of the underlying investments and determines fair
value of the alternative investments by evaluating the valuation of the underlying
investments, we may similarly choose to perform audit procedures to test the valuation of
the underlying investments.
(1) Obtain information gathered by entity management regarding their evaluation of the
investment’s valuation, and understand the nature and results of any procedures
performed by management to quantitatively evaluate the valuation of the investment.
Consider the work performed by entity management in planning and performing our
audit procedures.

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Deloitte & Touche LLP - Form 1840S (6-11)

(2) Obtain a detailed listing of the investee’s underlying investments (if not already
obtained as a part of procedures to test existence) and understand the types of
investments held at the balance sheet date.
(3) Obtain an overall understanding of the nature of the underlying investments, the
strategy of the alternative investment, and the method and significant assumptions
used by the fund manager to value the underlying investments.
(4) Using the detailed listing of the investee’s underlying investments on a security-by-
security basis obtained to test existence, make an audit sample of investments for
testing as of the balance sheet date.
(5) Perform valuation procedures to test underlying investments based on the nature of
the investment and the information available:
a. For investments in equity securities that have readily determinable fair values
and all investments in debt securities, perform the following:
i. Independently vouch to market prices.
b. For investments without readily determinable fair values (i.e., direct
investments and alternative investments), perform one of the following:
Direct Investments:
i. Test the estimates obtained from third-party pricing services.
ii. Test management’s valuation model, assumptions, and data.
iii. Develop an independent estimate.
iv. Test subsequent or recent transactions.
Alternative Investments:
v. Obtain audited financial statements for the underlying investment.
vi. Test the valuation of the investment in total by comparison to a relevant
transaction near the balance sheet date.
vii. Test the valuation of the investment in total by testing the activity during
the period since the last audit date of the investee (or the date of purchase,
if later).
viii. Test the underlying investment.

Possible Procedure 7 — Test Fair Value Measurements — Alternative


Investments, Recent Transactions
A. For alternative investments selections made to test existence, compare the fair value
measurement to relevant subsequent or recent transactions by performing the following:
(1) When using a subsequent or recent event or transaction to substantiate a fair value
measurement, we consider only those events or transactions that reflect circumstances
existing at the balance sheet date. Accordingly, if a market transaction involving an
identical financial instrument occurring near the balance sheet date has been

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Deloitte & Touche LLP - Form 1840S (6-11)

identified, consider whether the facts and circumstances of the transaction are such
that the transaction value is a relevant reference for the entity’s fair value
measurement at the balance sheet date.
a. Evaluate whether the event or transaction is reflective of the price that would be
received to sell an asset or paid to transfer a liability in an orderly (i.e.,
nondistressed) transaction between market participants at the measurement date.
b. For an event or transaction occurring after the balance sheet date, evaluate if the
event or transaction reflects changes in circumstances occurring after the
balance sheet date and thus does not represent relevant and reliable evidence of
the fair value measurement at the balance sheet date.
c. For an event or transaction occurring before the balance sheet date, evaluate if
circumstances have changed from the transaction date to the balance sheet date
such that the event or transaction does not represent relevant and reliable
evidence of the fair value measurement at the balance sheet date.
(2) If we conclude that an event or transaction near the balance sheet date is
representative of the fair value measurement at the balance sheet date, compare the
transaction to the recorded investment balance.
(3) Obtain details of the transaction identified and evaluate whether the facts and
circumstances of the transactions are such that the transaction value is a relevant
reference for the value of the entity’s investment at the balance sheet date. That
evaluation ordinarily would consider the following factors among others:
a. Whether the process used for the settling the transaction is the same process that
is used by the investee for financial reporting.
b. Whether there are holdbacks or potential true-ups subsequent to the balance
sheet date.
c. Whether the parties to the transactions were willing buyers and sellers, as
opposed to parties to a distress sale.
(4) Evaluate the results of test.

Possible Procedure 8 — Test Fair Value Measurements — Alterative


Investments, Rollforward
A. For alternative investment selections made to test existence, where the investor entity’s
management fulfills its responsibilities by evaluating the valuation of the selected
alternative investment in total, we may similarly choose to perform audit procedures to test
the valuation of the investment in total. A frequent approach to evaluating the valuation of
an investment in total is to rollforward the investment balance from the date that the
investee was last audited (or the date of the initial investment, if later), ordinarily not from
a date beyond one year from the entity’s year-end balance sheet date.
(1) For each alternative investment selected in Procedure A in this section for which its
fair value will be tested in total by testing activity from the date the investee was last
audited (or the date of initial investment, if later), perform the following:

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Deloitte & Touche LLP - Form 1840S (6-11)

a. Obtain an overall understanding of the nature of the underlying investments and


the strategy of the alternative investment. If possible, obtain a detailed listing of
the investee’s underlying investments and understand the types of investments
held.
b. Prepare an analysis to rollforward the investment balance from the date of the
last audited financial statements to the balance sheet. If entity management has
prepared an analysis which rolls forward the investment balance from the date
of the last audited financial statements (or from the date of initial investment if
later) to the balance sheet date, obtain that analysis for testing and perform the
following:
i. Agree the beginning balance of the rollforward analysis to the data in the
most recently audited financial statements of the investee (or to evidence
of the initial investment, if it occurred after the date of the most recently
audited financial statements) and to the confirmation received. Agree
significant reconciling items, if any, to supporting documents and test as
appropriate. Investigate, evaluate, and document whether differences, if
any, are misstatements.
ii. Agree the recorded investment balance at the end of the rollforward period
to the unaudited capital statement or other evidence of the investment’s
value received by investor from the investee and direct confirmation
received if applicable. Agree significant reconciling items, if any, to
supporting documents and test as appropriate. Investigate, evaluate, and
document whether differences, if any, are misstatements.
iii. Agree investment activities during the rollforward period (investments and
withdrawals made) to the confirmation obtained to test existence or other
supporting evidence. Agree significant reconciling items, if any, to
supporting documents and test as appropriate. Investigate, evaluate, and
document whether differences, if any, are misstatements.
iv. Evaluate whether the expected rate of return during the rollforward period
developed by entity management is reasonable, or develop our own
expected rate of return. Identifying or developing a reasonable expected
rate of return will vary depending on the strategy of the investment and the
nature of the underlying investments.

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Deloitte & Touche LLP - Form 1840S (6-11)

For example, we or entity management may identify an index or


benchmark which is publicly available and which is deemed relevant for
comparison to the performance of the investment, in terms of the nature of
the investment’s underlying investments and/or investment strategy. A
comparison then needs to be performed, on a historical basis, to
understand the relationship of the index or benchmark with the
performance of the investment to understand the relative performance of
the investment to the index or benchmark. Inquiries/information requests
of the fund manager may be necessary to evaluate whether there have
been significant changes in the underlying investments which require
consideration in estimating the rate of return for the investment. The
expected rate of return during the rollforward period may be the
performance of the index or benchmark during that period, adjusted for
the expected over- or under-performance of the investment based on the
historical correlations observed.
In other situations, a relevant external benchmark may not be identifiable.
In those situations, we or entity management develop an expectation of the
current period’s return having considered several factors including:
 The historical return of the investment based on previously received
audited financial statements
 Changes, if any, in the nature and type of the underlying investments
 Extent of consistency in valuation methods and significant
assumptions used by the fund manager in valuing the underlying
investments
 Impact of market conditions broadly, or even more specifically, as it
relates to industries for which the investment is invested, on expected
valuation results
 Significant transactions (e.g., IPO) that affected the value of the
underlying investments
 Life cycle of the investment and its overall investment strategy.
In considering the above factors, inquiries of the fund manager may be
necessary and, in some instances, additional information may be needed
including details of underlying investments at other times during the
period. If we are not provided with details of investments at other times
during the period, consider other evidence which might be indicative of
changes, or the absence of changes, to the underlying investments. For
example, certain investment structures (e.g., private equity funds) readily
make purchases and sales of underlying investments known to the
investors through required capital calls and liquidations.
v. Apply the expected rate of return during the rollforward period to the
average invested balance during the rollforward period to arrive at an
expected investment balance at the balance sheet date. Compare the

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Deloitte & Touche LLP - Form 1840S (6-11)

expected investment balance to the entity’s recorded investment balance at


the end of the rollforward period.
vi. Determine the threshold needed to identify a significant difference
between the expected investment balance and the recorded balance.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF


INVESTMENTS

Possible Procedure 1 — Management Inquiry


A. Inquire of management as to whether another party may have claim to the investment (i.e.,
that the investment is pledged as collateral to a loan).

Possible Procedure 2 — Review Documentation


A. Review documentation to determine if another party may have claim to the investments
(i.e., that the investment is pledged as collateral to a loan). Consider reviewing the
following:
(1) Information received in conjunction with Procedures 1 and 2 to test for Existence
(2) Minutes from meetings of those charged with governance
(3) Significant new agreements
(4) Covenant calculations.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF INVESTMENTS

Guidance — The procedure groups listed under the Completeness assertion for Cash may
be relevant when designing procedures to address the Completeness assertion for
Investments (i.e., Possible Procedure 2 below is similar to that under the Existence
assertion for Cash)

Possible Procedure 1 — Confirm Investments — Send Blank Confirmations


A. For confirmations sent in Possible Procedure 2 for testing of the Existence assertion above,
rather than requesting a confirmation of a specific investment in a security, leave the
confirmation blank and request custodian or third party to confirm the equity securities
held and the number of shares held.

Possible Procedure 2 — Perform Tests of Details on Bank Reconciliations


A. For those bank accounts selected to test existence of cash, perform the following:
(1) Examine bank reconciliations and determine if any unreconciled items represent
unrecorded purchases of investments.

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Deloitte & Touche LLP - Form 1840S (6-11)

INVESTMENTS IN EQUITY SECURITIES ACCOUNTED FOR UNDER THE COST


METHOD (ASC 325) OR EQUITY METHOD (ASC 323)

ACCOUNT BALANCE ASSERTION — EXISTENCE OF INVESTMENTS

Possible Procedure 1 — Perform Inspection of Investments


A. Obtain the investments trial balance and the reconciliation of the investments trial balance
to the general ledger.
(1) Agree applicable amounts from the investments trial balance and reconciliation to the
general ledger and trace significant reconciling items, if any, to supporting
documents.
B. Make an audit sample of investments physically held by the entity. For each selection,
perform the following:
(1) Physically inspect selected securities held by the entity.
(2) Agree information obtained from the inspection of securities (e.g., as to descriptions,
number of units held, registered holder) to the general ledger. Prepare, or have the
entity prepare, reconciliations of exceptions. Trace reconciling items to supporting
documents.

Possible Procedure 2 — Confirm Investments


A. Obtain the investments trial balance and the reconciliation of the investments trial balance
to the general ledger.
(1) Agree applicable amounts from the investments trial balance and reconciliation to the
general ledger and trace significant reconciling items, if any, to supporting
documents.
B. Make an audit sample of investments not physically held by the entity. For each selection,
perform the following:
(1) Prepare, or have the entity prepare, confirmation requests for the investments
selected. On the confirmation, consider including a listing of securities on a security-
by-security basis. Mail the confirmation requests under our control, determine that the
requests are properly addressed (i.e., obtain audit evidence about the accuracy and
completeness of addresses provided by the entity), and request that all replies be sent
directly to our office.
(2) Send second requests for nonreplies.
(3) Compare replies to requests (e.g., as to descriptions, number of units held, registered
holder). Prepare, or have the entity prepare, reconciliations of exceptions. Trace
reconciling items to supporting documents.
(4) Trace nonreplies to share purchase or similar agreements and other documentation
supporting the investor’s interest. Vouch relevant cash receipts and disbursements
related to purchases and sales.

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Deloitte & Touche LLP - Form 1840S (6-11)

Possible Procedure 3 — Test the Reconciliation of the Third-Party Custodian’s


Records to the General Ledger
A. Obtain a schedule of investments showing beginning balance, purchases, sales, and ending
balance.
(1) Agree the components from the third-party custodian’s records to the schedule.
B. Test the summarization of the schedule and agree balances to the general ledger. Trace
significant reconciling items, if any, to supporting documents.

Possible Procedure 4 — Confirm Investments — Direct Investments and Other


Alternative Investments
A. Obtain the investments trial balance and the reconciliation of the investments trial balance
to the general ledger.
(1) Agree applicable amounts from the investments trial balance and reconciliation to the
general ledger and trace significant reconciling items, if any, to supporting
documents.
B. Make an audit sample of investments not physically held by the entity. For each selection,
perform the following:
(1) Prepare, or have the entity prepare, confirmation requests for the investments
selected. On the confirmation, consider including a listing of securities on a security-
by-security basis. Confirmation of investments in the aggregate (e.g., ownership
percentage of the fund or shares/units of the fund held) versus on a security-by-
security basis for investments held by the fund does not by itself constitute adequate
evidence with respect to the existence assertion. If the fund is only willing to confirm
the entity’s investment in the aggregate, perform additional procedures such as those
in Procedure C to test the existence assertion.
a. When the audited balance sheet date of the investee entity differs from the
balance sheet date of the investor entity, confirm the information above as of the
investor entity’s balance sheet date and also as of the balance sheet date of the
investee’s audited financial statements, including the capital activity for both the
period from the audited balance sheet date of the investee to the entity’s year-
end as well as for the period from the beginning of the entity’s fiscal year to the
balance sheet date of the investee’s audited financial statements. [For example,
if the entity’s year-end is June 30, 20x6, and the investee’s year-end audited
statements are as of December 31, 20x5, the confirmation would confirm
investment balances as of both December 31, 20x5, and June 30, 20x6, and
capital activity for the period July 1, 20x5, to December 31, 20x5, and from
December 31, 20x5, to June 30, 20x6.]
(2) Mail the confirmation requests under our control, determine that the requests are
properly addressed (i.e., obtain audit evidence about the accuracy and completeness
of addresses provided by the entity), and request that all replies be sent directly to our
office.
(3) Send second requests for nonreplies.

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Deloitte & Touche LLP - Form 1840S (6-11)

(4) Compare replies to requests (e.g., as to descriptions, number of units held, registered
holder). Prepare, or have the entity prepare, reconciliations of exceptions. Trace
reconciling items to supporting documents.
(5) Trace nonreplies to share purchase or similar agreements and other documentation
supporting the investor’s interest. Vouch relevant cash receipts and disbursements
related to purchases and sales.
C. Determine whether we have received sufficient audit evidence for the existence assertion:
(1) If we have received a confirmation in the aggregate and we have obtained audited
financial statements of the investee as of the entity’s year-end prepared on the same
basis of accounting, or if the confirmation was not returned but we have received
audited financial statements with individual schedules of partners’ capital, the
existence assertion is deemed to have been satisfied.
(2) If the confirmation is not returned or if the confirmation returned did not include a
detailed listing on a security-by-security basis and we did not receive audited
financial statements of the investee as of the entity’s year-end prepared on the same
basis of accounting, perform alternative procedures to test existence of the selection.
Completion of only one of the procedures noted below would ordinarily not
constitute sufficient appropriate audit evidence to test the existence assertion.
Alternative procedures may include performing a combination of the following:
a. Review executed partnership, trust, limited liability corporation, or similar
agreements.
b. Review periodic statements from the fund or trustee reflecting investment
activity and compare activity with amounts recorded by the investor.
c. Vouch relevant cash receipts and disbursements related to purchases and sales.
d. Observe or review documentation of management site visits or telephone calls
to investee funds.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


INVESTMENTS

Possible Procedure 1 — Perform Procedures to Test Recorded Balance of


Equity Method Investments
A. For investments selected to test existence, obtain the investee financial statements
supporting the entity’s carrying amount and perform the following procedures:
(1) If the statements were audited by us or by other independent accountants, recompute
the entity’s portion of the investee’s income or loss and equity, and trace any
dividends received or returns of prior amounts invested to supporting documents.
a. Evaluate the audited financial statements and conclude whether anything noted
within the financial statements or the auditors’ report has an impact on our risk
assessment or our ability to rely on the audited financial statements as audit
evidence. Consider the following items when evaluating the financial

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Deloitte & Touche LLP - Form 1840S (6-11)

statements:
 Qualifications and reputation of the audit firm
 Nature of the auditors’ report (e.g., qualified or adverse, whether there is
an emphasis of a matter paragraph), and any other unusual characteristics
which may increase professional skepticism as to the validity of the audit
report or financial statements (e.g., missing city or letterhead on opinion,
poorly worded opinion)
 Accounting principles used and the valuation policy of the underlying
investments
 Illiquid or unusual investments
 Potential material loss contingencies
 Whether a concentration exists in particular securities
 Whether other relevant disclosure items are present (e.g., significant
related parties).
b. If the statements were not audited, perform such other auditing procedures as
are necessary to obtain assurance about the investee’s financial information.
Recompute the entity’s portion of the investee’s income or loss and equity, and
trace any dividends received or returns of prior amounts invested to supporting
documents.
(2) If a time lag between the date of the entity’s financial statements and those of the
investee exists:
a. Determine whether recording the investment on a lag is appropriate by
evaluating whether periodic information received from the investee (e.g.,
unaudited interim financial statements, capital statements, performance reports,
statements of net asset value, or statements of unit value) is derived from
investee accounting records that are substantively the same as financial
statements such that they are appropriate for the investor entity’s financial
reporting.
b. Determine if the time lag has a material effect on the entity’s financial
statements and whether the entity’s management has properly considered the
lack of comparability.
c. Verify that the investor recorded its share of the earnings or losses of an investee
from the most recent available financial statements (or financial information
derived from investee accounting records that are substantively the same as
financial statements), and that there is a consistent lag in reporting from period
to period.
d. Obtain written confirmations from the investee as to the lack of availability of
financial data as of the investor’s year-end.
(3) Read information in the investor’s files that relates to the investee (e.g., investee
minutes, budgets, and cash flows information about the investee) and make inquiries

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Deloitte & Touche LLP - Form 1840S (6-11)

of investor management about the investee’s financial results.


(4) Verify that dividends received by the investor are recorded as a reduction to the
investment balance.
(5) If there is a difference between the cost of the investment and the amount of
underlying equity in net assets of the investee at the date of investment, determine
that the entity has accounted for the difference as if the investee were a consolidated
subsidiary. [Note: For investments that were not acquired in the current year, test only
the amortization of the basis difference, if applicable.]
a. If the investor is unable to relate the difference to specific accounts of the
investee, inquire and document the result of the inquiry if the difference is
considered to be, and has been recorded as, goodwill.
b. Verify that the goodwill has been held unamortized.
(6) If equity method investments (and net advances) have been reduced to zero, verify
that the equity method of accounting has been discontinued, unless one or both of the
following circumstances exists:
a. The investor’s potential loss is not limited to the amount of its original
investment because of a guarantee of the investee’s obligations or other
commitment to provide further financial support. Obtain and read the
investment agreement to determine whether this circumstance exists.
b. Imminent return to profitable operations by the investee appears to be assured.
Obtain supporting documentation (e.g., investee profit analyses provided by the
investee to the entity) to verify whether this circumstance exists.
(7) If the equity method has been discontinued and the investee subsequently reports net
income, verify that the entity resumed the application of the equity method only after
the investor’s share of net income equaled its share of net losses not recognized
during the period in which the equity method was suspended and perform the
following:
a. Obtain and read the investee’s financial statements for the period in which the
equity method was suspended.
b. Recalculate the net loss that would have been allocated to the investor if the
equity method was being applied and compare this to the investor’s share of net
income. Verify the net income equaled its share of net losses not recognized
during the period in which the equity method was suspended.
(8) If an investee has outstanding cumulative preferred stock, verify that the entity
computed its share of earnings (losses) after deducting the investee’s dividends
thereon, whether or not the dividends are declared and perform the following:
a. Obtain and test the entity’s (i.e., investor’s) calculation of its share of earnings
(loss).
b. Verify the entity (i.e., investor) computed its share of earnings (losses) after
deducting the investee’s dividends thereon, whether or not the dividends are
declared.

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Deloitte & Touche LLP - Form 1840S (6-11)

(9) If the investor’s level of ownership falls below that necessary to qualify for use of the
equity method (i.e., if they lose the ability to influence policy), either through the sale
of a portion of an investment by the investor, sale of additional stock by an investee,
or other transactions and the investor may thereby lose the ability to influence policy,
obtain and test the documentation management has to support the change in
significant influence of the related investment (e.g., sale agreement of a portion of the
investment) and then determine whether:
a. The entity discontinued accruing its share of the earnings or losses of the
investee.
b. The accrued earnings or losses that relate to the stock retained by the entity
remained as a part of the carrying amount of the investment. [Note: The
investment account is not to be adjusted retroactively.]
c. If the dividends received by the entity no longer using the equity method exceed
the entity’s share of earnings since discontinuing the method, the carrying
amount of the investment has been reduced by the excess.
d. If the underlying equity security has a readily determinable fair value, the
investor has begun accounting for the investment under ASC 320-10.
e. The entity offset its proportionate share of an investee’s equity adjustments for
Other Comprehensive Income (OCI) against the carrying value of the
investment at the time significant influence was lost. [Note: If the investor’s
proportionate share of an investee’s equity adjustment for OCI is greater than
the carrying value of the investment, the excess is recognized in income.]
(10) Obtain documentation supporting the elimination of the intercompany profit and
losses (between the entity and the investee) until realized. Recalculate the amount that
is eliminated and verify that such amount has been eliminated. [Note: Elimination of
intercompany profits and losses is generally based on the investor’s percentage of
ownership of the investee.]

Possible Procedure 2 — Perform Procedures to Test Recorded Cost of


Investments Held at Cost
A. For each selection made to test the existence of investments, perform the following:
(1) Agree the recorded costs of the selected securities to supporting documents (e.g.,
broker’s advice for investments purchased in the current period, or our prior-period
working papers for investments purchased in prior periods).

Possible Procedure 3 — Perform Procedures to Test Impairment of Equity and


Cost Method Investments
A. Obtain and document your understanding of how the entity assesses impairment of its
investments including how it assesses impairment during each reporting period.
(1) Obtain the documentation supporting the entity’s impairment assessment.
a. Verify that, for each investment, the entity’s impairment assessment has been

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Deloitte & Touche LLP - Form 1840S (6-11)

performed for the equity method investment as a whole.


B. Obtain the entity’s impairment calculation consisting of fair value measurement of the
individual investments.
(1) Test the impairment calculation by obtaining an understanding of:
a. The factors considered and assumptions made by management in developing the
fair value used to determine whether impairment exists.
b. The sources of data relevant to these factors and assumptions and the
procedures used to obtain the data.
c. The methods used to calculate fair value.
(2) Test the mathematical accuracy of the impairment calculation.
(3) Perform applicable procedures outlined in the Investments in Equity Securities
Recorded at Fair Value That Do Not Have Readily Determinable Fair Values (ASC
820 and ASC 825) guide noted below:
a. Direct Investment — External Pricing Sources
b. Direct Investment — Model
c. Direct Investment — Independent Estimate
d. Direct Investment — Subsequent or Recent Transactions
e. Alternative Investments — Audited Financial Statements
f. Alternative Investments — Underlying Investments
g. Alternative Investments — Subsequent or Recent Transactions
h. Alternative Investments — Rollforward
(4) Evaluate the reasonableness of assumptions and methods used in the calculation and
document our conclusion.

Possible Procedure 4 — Perform Procedures to Test the Determination as to


Whether the Security Has Other-Than-Temporary Impairment (OTTI) — Cost and
Equity Method Investments
A. For those individual securities that are determined to be impaired, obtain the
documentation of how the entity determined that the decline in fair value below the
amortized cost basis was other-than-temporary.
(1) Hold discussions with key management officials in order to obtain an understanding
of the entity’s process for assessing securities for OTTI. Obtain an understanding of
the entity’s process and specifically perform the following:
a. Document our assessment of whether the process provides reasonable assurance
that all available relevant and reliable evidence concerning declines in fair
values below cost is identified and evaluated by responsible personnel.
b. Evaluate for reasonableness the entity’s process to determine when an OTTI

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Deloitte & Touche LLP - Form 1840S (6-11)

analysis is performed for individual securities (e.g., each reporting period).


c. Evaluate for reasonableness the entity’s process to determine which individual
securities require an OTTI analysis (e.g., has the entity considered appropriate
factors in determining which securities to assess for OTTI — magnitude of
unrealized loss position, duration of time in which fair value is below cost
basis).
d. Evaluate whether the entity is applying the appropriate accounting framework.
(2) Determine whether the entity uses a third-party investment manager to manage its
investment portfolio. If this is the case, perform the following:
a. Obtain and read the terms of the written contract between the entity and the
third-party investment manager.
b. Evaluate the extent of the investment manager’s authority to initiate sales and
purchase transactions. For example, does the investment manager have full
execution authority, or is the investment manager required to obtain preapproval
from entity management or the entity’s investment committee?
c. In the absence of a written contract between the entity and the third-party
investment manager, consider confirming the terms of the arrangement directly
with the third-party investment manager.
d. Based on these procedures, evaluate for reasonableness the entity’s process for
considering the use of third-party investment managers when assessing OTTI.
Note that the OTTI accounting framework differs based on whether the security
subject to the arrangement with the third-party investment manager is a debt or
equity security.
(3) Assess OTTI for those impaired securities not accounted for at fair value, and those
impaired securities accounted for at fair value with changes in fair value not recorded
through earnings.
a. Make selections from the listing of impaired equity securities not accounted for
at fair value, and impaired equity securities accounted for at fair value with
changes in fair value not recorded through earnings.
b. Test the fair value of the selected security, or agree the fair value per the entity
to valuation testing procedures performed elsewhere.
c. Agree the recorded amount for the security to the general ledger or trial balance.
d. If management has recorded impairment for the selected security during the
reporting period, agree the impairment to the entity’s accounting records and
obtain management’s supporting documentation for the impairment and test the
impairment calculation.
(4) Perform the following procedures for impaired equity securities:
a. Obtain the entity’s OTTI analysis and conclude whether the entity’s analysis is
consistent with its processes.
b. Evaluate for reasonableness the entity’s analysis as to whether an OTTI exists

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Deloitte & Touche LLP - Form 1840S (6-11)

for each selected impaired equity security by considering the entity’s intent and
ability to hold the security until full recovery.
c. If the equity security is not other-than-temporarily impaired, verify the
impairment amount (i.e., write-down to fair value) for the equity security is not
recognized.
d. If the equity security is other-than-temporarily impaired, verify the impairment
amount (i.e., write-down to fair value) for the equity security is recognized in
earnings.
(5) Evaluate sales of securities at a loss after the balance sheet date:
a. Inquire about and review debt and equity securities sold at a loss after the
balance sheet date. Evaluate whether securities sold at a loss after the balance
sheet date indicates an OTTI was present as of the balance sheet date.
(6) Perform a retrospective review to evaluate the entity’s past stated intent.
a. Make an audit sample of sales of equity securities made during the current
reporting period. Perform a retrospective review of the entity’s stated intent as
of the prior reporting period, and assess whether the intent stated in the prior
year was consistent with the subsequent action taken. If not, evaluate the
reasons why and whether there may be a possible bias on the part of
management in the current reporting period related to assertions made for debt
and equity securities.

Possible Procedure 5 — Perform Procedures to Test Dividends Received by


Cost Method Investments
A. Perform procedures to determine that stock dividends or stock splits received by an entity
were accounted for by reallocating the cost of the shares previously held with no effect on
income. [ARB 43, Ch 7B.09] [ ASC 505-20-30-7]
(1) Obtain and test supporting documentation related to any dividends received by an
entity in the current period. Verify the entity accounted for the transaction
appropriately.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF


INVESTMENTS

Possible Procedure 1 — Management Inquiry


A. Inquire of management as to whether another party may have claim to the investment (i.e.,
that the investment is pledged as collateral to a loan).

Possible Procedure 2 — Review Documentation


A. Review documentation to determine if another party may have claim to the investments
(i.e., that the investment is pledged as collateral to a loan). Consider reviewing the
following:

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Deloitte & Touche LLP - Form 1840S (6-11)

 Information received in conjunction with Possible Procedures 1 and 2 to test the


Existence assertion.
 Minutes from meetings of those charged with governance.
 Significant new debt agreements.
 Covenant calculations.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF INVESTMENTS

Guidance — The procedure groups listed under the Completeness assertion for Cash may
be relevant when designing procedures to address the Completeness assertion for
Investments (i.e., Possible Procedure 2 below is similar to that under the Existence
assertion for Cash).

Possible Procedure 1 — Confirm Investments


A. For confirmations sent in Possible Procedure 2 for testing of the Existence assertion above,
rather than requesting a confirmation of a specific investment in a security, leave the
confirmation blank and request custodian or third party to confirm the equity securities
held and the number of shares held.

Possible Procedure 2 — Perform Tests of Details on Bank Reconciliations


A. For those bank accounts selected to test existence of cash, perform the following:
(1) Examine bank reconciliations and determine if any unreconciled items represent
unrecorded purchases of investments.

Possible Procedure 3 — Test the Reconciliation of the Third-Party Custodian’s


Records to the General Ledger
A. Obtain a schedule of investments showing beginning balance, purchases, sales, and ending
balance.
(1) Agree the components from the third-party custodian’s records to the schedule.
B. Test the summarization of the schedule and agree balances to the general ledger. Trace
significant reconciling items, if any, to supporting documents.
C. Make an audit sample of disposals. For each selection, perform the following:
(1) Examine the documents authorizing the disposal. Verify the disposed investment is
excluded from the listing of equity securities that have readily determinable fair
values, and all investments in debt securities at the end of the period.

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Deloitte & Touche LLP - Form 1840S (6-11)

DERIVATIVE INSTRUMENTS AND HEDGE ACCOUNTING ON DERIVATIVE


INSTRUMENTS

ACCOUNT BALANCE ASSERTION — EXISTENCE OF DERIVATIVE


INSTRUMENTS

Possible Procedure 1 — Test Embedded Derivatives


A. Obtain management’s schedule of embedded derivatives that have been separated from
host contracts and those hybrid contracts reported at fair value.
B. Make an audit sample of embedded derivative contracts. Contracts with a negative value
are included as absolute values. For each selection, perform the following:
(1) Determine that the entity has properly identified and separated those embedded
derivatives for which all of the following criteria have been met:
a. The economic characteristics and risks of the embedded derivative are not
clearly and closely related to the economic characteristics and risks of the host
contract.
b. The entire hybrid contract is not already carried at fair value with changes in
fair value recorded through earnings.
c. A separate instrument with the same terms as the embedded derivative
instrument would be a freestanding derivative instrument (i.e., it has an
underlying, a notional amount or payment provision, requires no or small initial
net investment, and requires or permits net settlement).
(2) Verify that the entity has refrained from separating an embedded foreign currency
derivative instrument from the host contract, if the host contract is not a financial
instrument and it requires payment(s) denominated in (a) the functional currency of
any substantial party to the contract, (b) the currency in which the price of the related
good or service that is acquired or delivered is routinely denominated in international
commerce, (c) the local currency of any substantial party to the contract, or (d) the
currency used by a substantial party to the contract as if it were the functional
currency because the primary economic environment in which the party operates is
highly inflationary.
(3) Verify that the embedded derivative instrument can be identified and measured.

Possible Procedure 2 — Test Derivatives


A. Obtain the entity’s schedule of open financial derivative contracts (including those that are
(1) recognized as derivatives, (2) qualified for the normal purchases and normal sales scope
exception, and (3) nonderivative instruments used as hedging instruments) as of the end of
the year (or quarter, if this is a quarterly review), including embedded derivatives that are
required to be accounted for separately and perform the following:
(1) Test summarization of the schedule.
(2) Agree the ending balances to the subsidiary and general ledgers.

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Deloitte & Touche LLP - Form 1840S (6-11)

(3) Test reconciling items between subsidiary records and the general ledger.
B. When possible, disaggregate the population as follows:
(1) Contracts designated as normal purchases and normal sales, accrual (nonderivatives),
cash flow hedges, fair value hedges, net investment hedges, nondesignated
derivatives, and embedded derivatives
(2) Type of risk being hedged (e.g., interest rate, foreign currency, commodity, other)
(3) Type of contract (e.g., forwards, options, futures, structured deals)
(4) Method of hedge effectiveness used (e.g., short cut, long haul, critical terms match)
(5) Method of valuation used by the entity (e.g., internal model, recent transactions)
(6) New contracts entered into in the current period
(7) Contracts that were in place at the beginning of the period, which were modified in
the current period.
C. Make an audit sample of the fair value balance of open derivative contracts considering
disaggregated parts identified above. For each selection, perform the following:
(1) Test whether the contract meets the requirements to be a derivative.
(2) Confirm open contracts by performing the following:
a. Prepare, or have the entity prepare, confirmation requests for significant contact
terms on a contract-by-contract basis. Mail the confirmation requests under our
control, determine that the requests are properly addressed (i.e., obtain audit
evidence about the accuracy and completeness of addresses provided by the
entity), and request that all replies be sent directly to our office.
b. Send second requests for nonreplies.
c. Compare confirmation replies to the entity’s schedule(s) to validate existence of
derivative instruments.
d. Trace nonreplies to statements sent from the counterparty or broker.

Possible Procedure 3 — Using Tests of Details to Update Existence Tests


Performed at an Interim Date
A. Inquire into any significant changes in the entity’s policies, hedging strategies, and
procedures since the interim date. Investigate as necessary.
B. Review the entity’s updated files that were obtained at interim and segregate the old
contracts already subjected to testing from the new contracts.
C. Make an audit sample of the recorded ending fair values of new derivative instruments
entered into during the period from the interim date to the balance sheet date, and test those
new derivative instruments for existence.
D. For our selections made during interim, perform rollforward procedures, as appropriate
(e.g., modifications) to update our testing on those selections.

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Deloitte & Touche LLP - Form 1840S (6-11)

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF DERIVATIVE


INSTRUMENTS

Possible Procedure 1 — Test Completeness of Management’s Listing of


Derivatives
A. Perform the following procedures to test completeness of management’s listing of
derivatives:
(1) Inquire about and discuss the policies and procedures adopted by management for
identifying, evaluating, and accounting for derivative instruments, hedging activities,
and investments in securities with the entity official responsible for financial
instruments.
(2) Inquire of management (e.g., treasury department, purchasing department, CFO)
about aspects of operating activities that might present risks that could be hedged
using derivatives (e.g., interest rate risk, foreign exchange risk, commodity risk) and
whether those risks are managed.
(3) Review minutes of meetings of those charged with governance.
(4) Examine documents in the entity’s possession concerning financial instruments
including correspondence, invoices, and confirmations from broker firms, in order to
determine whether there is a counterparty entering into contracts with the entity that
we are not otherwise aware of.
(5) Examine contracts, lease agreements, preferred stock, and debt agreements for the
existence of embedded derivatives.
(6) Modify confirmations to be sent in Possible Procedure 2 to test the Existence
assertion to request all open positions be confirmed rather than the specific selected
position.

Possible Procedure 2 — Test Contracts Which Entity Has Elected the Normal
Purchase or Normal Sale Exceptions
A. Obtain a listing of contracts that management has concluded meet the Normal Purchase or
Normal Sale scope exception and perform the following procedures:
(1) For those items which are new contracts in the current year, verify that they meet all
of the following conditions:
a. The contract provides for the purchase or sale of something other than a
financial instrument or derivative instrument that will be delivered in quantities
expected to be used or sold by the reporting entity over a reasonable period in
the normal course of business.
b. The entity contemporaneously documented the designation of the contract as a
normal purchase or normal sale.
c. For forward contracts to buy or sell in the future that contain net settlement
provisions, the entity documented the basis for concluding that it is probable
that the contract will not settle net and will result in physical delivery. The entity

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Deloitte & Touche LLP - Form 1840S (6-11)

considered the risk that parties to the contract may not be able to perform on the
contract.
d. Option contracts that would require delivery of the related asset at an
established price under the contract only if exercised are not eligible to qualify
for the normal purchases and normal sales exception, except sales agreements
that are capacity contracts and the entity has documented that the agreement
meets the criteria for this exception.
e. For forward contracts that contain optionality features, either (1) those features
do not modify the quantity of the asset to be delivered under the contract, (2) the
option component permits the holder only to purchase or sell additional
quantities at the market price at the date of delivery or (3) the contract is a sales
agreements that is a capacity contract, and the entity has documented that the
agreement meets the criteria for this exception.
f. The price of the contract is not based on an underlying that is not clearly and
closely related to the asset being sold or purchased.
g. The price of the contract is not denominated in a foreign currency.
h. The contract meets the other conditions for applying the normal purchases and
normal sales exception.
i. Management is able to accurately predict the probability of the forecasted
physical settlement.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


DERIVATIVE INSTRUMENTS

Possible Procedure 1 — Testing Valuation of Financial and Commodity


Derivative Instruments — Level 1 Inputs (ASC 820-10)
A. Test the valuation of the derivative selections made to test the Existence assertion above
that are measured and recorded using Level 1 inputs in the fair value hierarchy in their
entirety by performing the following procedures:
(1) Obtain the entity’s evidence supporting the fair value measurement. Obtain and
include in the working papers evidence of the price used by the entity. The entity’s
source of the price may be the market itself (e.g., financial publications, the
exchanges, NYMEX, COMEX), or a third-party pricing service based on market
sources (e.g., Bloomberg, Reuters, IDC, JJ Kenny Drake).
(2) Independently obtain the market price. Our source for the market price may be the
same source that the entity used or a different source than that used by the entity. The
source may be the market itself [e.g., financial publications, the exchanges, the
National Association of Securities Dealers Automated Quotations System
(NASDAQ), Pink Sheets LLC], or a third-party pricing service based on market
sources (e.g., Bloomberg, Reuters, IDC, JJ Kenny Drake) that we deem to be
reputable.
(3) Estimate the fair value by multiplying the market price obtained times the quantity

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Deloitte & Touche LLP - Form 1840S (6-11)

held by the entity.


(4) Compare our estimate of fair value to the fair value used by the entity and evaluate
differences, if any:
a. If we independently obtained the market price from the same source used by the
entity, we expect the fair value estimate not to differ and differences should be
evaluated.
b. If we obtained a market price from a source different than the source used by
the entity, such market price could differ yet still be reliable. Differences in fair
value that do not exceed an appropriate range are acceptable when using market
prices from different sources. If the difference is not within the range, the
amount of the difference outside of the range is a misstatement.
(5) Recalculate the unrealized gains or losses based on the results of the fair value
measurement at period-end compared to the prior-year fair value measurement or
transaction price if purchased during the current year.
(6) Based on the results of the procedures performed above, evaluate whether the fair
value measurement is appropriately identified as falling within Level 1 in the fair
value hierarchy in its entirety (i.e., calculated from a quoted price unadjusted in active
markets for an identical asset or liability).

Possible Procedure 2 — Testing Entity’s Model, Assumptions, and Underlying


Data of Levels 2 and 3 (ASC 820-10) Inputs of Financial and Commodity
Derivatives
A. Using the selections made during the testing of the existence assertion understand,
document, and evaluate the reasonableness of the methods and key assumptions used by
management by performing the following, as applicable:
(1) Evaluate whether the valuation technique or techniques (i.e., valuation methodology)
is/are appropriate in the circumstances and whether the technique or techniques used
for determining fair value is/are applied consistently with the preceding periods.
Consider the following:
a. Whether the valuation technique (i.e., method) of measurement maximizes the
use of observable inputs and minimizes the use of unobservable inputs.
b. Whether a single valuation technique or multiple valuation techniques is/are
appropriate in the circumstances and for which sufficient data is available.
c. In instances in which management has determined that different valuation
techniques result in a range of significantly different fair value measurements,
how the entity investigated the reasons for these differences in establishing its
fair value measurements.
d. In circumstances when multiple valuation techniques were employed, whether
the results were evaluated and weighted appropriately to identify a single
estimate within a reasonable range that is most representative of the fair value.
e. Whether the valuation technique is appropriate in relation to the business,

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Deloitte & Touche LLP - Form 1840S (6-11)

industry, and environment in which the entity operates.


(2) Evaluate whether a change in the valuation technique or its application (e.g., a change
in its weighting when multiple valuation techniques are used) is appropriate if the
change results in a measurement that is equally or more representative of fair value in
the circumstances (e.g., new markets develop, new information becomes available,
information previously used is no longer available, or valuation methods improve).
a. If the item was tested in the prior year, compare to the valuation technique or
techniques used in the prior year for consistency.
b. Determine that any revisions resulting from a change in a valuation technique or
its application (e.g., a change in its weighing when multiple valuation
techniques are used) are accounted for as a change in accounting estimate.
c. Assess reasonableness of the valuation assumptions (or “inputs”) used in the
fair value analysis and whether the valuation assumptions are consistent with
what market participants would use in pricing the item.
(3) Evaluate whether management used relevant information that was reasonably
available at that time.
(4) Evaluate whether management used observable inputs first (Level 1, then Level 2,
then Level 3) to the extent possible in determining the valuation assumptions
following the fair value hierarchy.
(5) Evaluate whether an adjustment for risk is necessary to any of the valuation
assumptions used by management. An adjustment for risk would be appropriate if the
identified market participants would include the adjustment in pricing the asset or
liability.
(6) Evaluate whether the entity has reflected the nonperformance risk in measuring the
fair value of a liability, thereby considering the effect of changes in its credit risk
(credit standing) on the fair value of a liability as well as credit enhancements related
to the liability, if any.
(7) Agree information used in developing the key valuation assumptions to appropriate
supporting documentation.
(8) Consider whether the valuation assumptions, taken individually and as a whole, are
realistic and consistent with the following:
a. The general economic environment, the economic environment of the entity’s
specific industry, and the entity’s economic circumstances.
b. Existing market information.
c. The entity’s plans and experience, to the extent currently applicable, including
management’s expectations for the outcome of specific objectives and strategies
adjusted for any considerations market participants would make.
d. Valuation assumptions made in prior periods. Compare assumptions used in the
prior year to those used in the current year. Inquire as to material variances
between the periods.

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Deloitte & Touche LLP - Form 1840S (6-11)

e. Other matters relating to the financial statements (e.g., assumptions used by


management in other fair value measurements).
f. The risk associated with cash flows, including the potential variability in the
amount and timing of the cash flows and the related effect on the discount rate.
B. If management’s methods and assumptions were reasonable, test the accuracy and
completeness of the data used by management by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures may include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
C. Identify and obtain audit evidence to support the key assumptions underlying the estimate.
D. In instances when the audit evidence is inconsistent among differing sources, perform
additional audit procedures to resolve the inconsistency.
E. Using the appropriate data, assumptions, and methodology, recompute management’s
estimate.

Possible Procedure 3 — Developing Independent Expectation of Derivatives


with Level 2 or 3 (ASC 820-10) Inputs
A. Using the selections made during the testing of the Existence assertion, develop a point
estimate or range.
B. When developing a point estimate or range, obtain audit evidence to support that the data
used to make our point estimate or range is independent and reliable, and if we are using
information produced by the entity that it is accurate and complete.
C. When using information that is produced by the entity, obtain audit evidence about the
accuracy and completeness of the data by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures ordinarily include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).

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Deloitte & Touche LLP - Form 1840S (6-11)

b. Agreeing summary information to underlying data or third-party source


documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
D. In instances when the audit evidence to be used in forming our expectations is inconsistent
among differing sources, perform additional audit procedures to resolve the inconsistency.
E. Compare the recorded amount(s) to our point estimate or range and evaluate any
differences.

Possible Procedure 4 — Testing Valuation of Derivative Instruments — Level 2


and 3 (ASC 820-10) Inputs, External Pricing Source
A. Consider involving an Internal Fair Value Specialist from Regulatory and Capital Markets
within Deloitte & Touche LLP, the National Securities Pricing Center (NSPC), or a
Financial Instruments and Valuation Subject Matter Resource if the audit engagement team
does not have the requisite expertise regarding determination of fair value measurements
for Level 2 or Level 3 derivatives.
B. For our selections made to test the Existence assertion, which are derivatives for which
quoted markets prices in active markets are not available and for which the entity obtained
estimates of fair value from external pricing sources (i.e., brokers or other third-party
sources such as pricing services) based on proprietary valuation models, perform the
following procedures to test valuation:
(1) Determine whether estimates from more than one external pricing source (i.e., broker
or other third-party source) are needed to substantiate the fair value. For example,
obtaining estimates from more than one source is appropriate if either of the
following occur:
a. The external pricing source has a relationship with an entity that might impair
its objectivity, such as an affiliate or a counterparty involved in selling or
structuring the product.
b. The valuation is based on assumptions that are highly subjective or particularly
sensitive to changes in the underlying circumstances.
(2) Test the entity’s evidence of fair value obtained from external pricing source(s) (i.e.,
brokers or other third-party sources such as pricing services) as follows:
a. Evaluate the entity’s evidence it received from external pricing source(s) by
performing the following:
i. Obtain the entity’s documentation of the fair value obtained from the
external pricing source(s) [e.g., broker quote(s) and/or report(s) from
pricing service(s)].
ii. Evaluate whether any disclaimers or limitations on the entity’s external
pricing documentation are such that we may not rely upon it for audit
purposes. Consider consulting with a Subject Matter Resource when
external pricing documentation contains language that may limit our
ability to rely on the price quote for the purposes of our audit.

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Deloitte & Touche LLP - Form 1840S (6-11)

iii. Consider any other information contained in the entity’s external pricing
documentation that may have an effect on the price quote being provided.
b. Evaluate the reputation of each broker or other third-party pricing source by
performing the following:
i. Document our understanding of the reputation of the broker or other third-
party pricing source.
ii. Evaluate whether the broker or other third-party pricing source is viewed
as reputable for pricing the financial instrument. The NSPC may be of
assistance to the audit engagement team.
c. For each price quote (excluding those we received from our NSPC), confirm the
quote with the broker or other third-party pricing source by performing the
following:
i. Prepare, or have the entity prepare, confirmation requests. Confirm the
financial instrument description/identifier and the market price quote as of
the appropriate measurement date.
ii. Mail the confirmation requests under our control, determine that the
requests are properly addressed (i.e., obtain audit evidence about the
accuracy and completeness of addresses provided by the entity), and
request that all replies be sent directly to our office.
iii. Send second requests for nonreplies and request the entity to follow up, if
necessary.
iv. Compare replies to the entity’s financial reporting records (e.g., as to
descriptions, number of units held, registered holder). Examine supporting
documents for any reconciling items.
v. Evaluate whether any disclaimers or limitations included in the
confirmation are such that we may not rely upon it for audit purposes.
Consider consulting with a Subject Matter Resource when the
confirmation contains language that may limit our ability to rely on it for
the purposes of our audit.
vi. If replies are not received, perform alternative procedures. An example of
an alternative procedure is to agree the price quote to the pricing service
with the assistance of our NSPC if the confirmation was sent to a pricing
service to which the NSPC also subscribes.
C. Understand the method and evaluate the assumptions used by the broker or other third-
party pricing source in developing the estimate by performing the following:
(1) When obtaining fair value estimates from multiple third-party sources, such
understanding and evaluation is needed for at least one of the fair value estimates
obtained. The inquiries below need to be made of a pricing source to understand the
method used. Because several of those questions require an understanding of
financial modeling and familiarity with appropriate market inputs, the related
responses to the inquiries are to be evaluated by a professional with sufficient

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Deloitte & Touche LLP - Form 1840S (6-11)

knowledge in these areas. A senior and experienced Subject Matter Resource or a


professional in the NSPC generally would qualify. The working papers need to
include documentation of substantive and complete responses to the following
questions:
a. Is the pricing source independent of the entity and of the security being
measured?
b. Is the pricing source reputable and nationally recognized?
c. If a broker, does the broker trade or make a market in this particular security?
(A broker would be considered to make a market in a security if that broker
stands ready to buy or sell a particular security in the over-the-counter market at
prices the broker dealer has quoted.)
d. If a pricing service, how does the pricing service obtain prices for each type of
security?
e. Is the quote from the pricing source based on a model or recent trades?
f. If based on a model, what type of model is used to price each type of security?
g. If based on a model, what are the significant or sensitive assumptions, inputs,
and sources of inputs included in the models for each type of security?
Responses include quantitative information regarding inputs as well as
qualitative information. Ranges of quantitative information, rather than point
estimates, may be acceptable in the circumstances.
h. If based on a model, are the inputs based on available market data or are the
inputs unobservable in the market?
i. If based on a model, are the models, assumptions, and inputs the same as used
for our own books and records?
j. If based on a model, was the model subject to price validation procedures by the
pricing source?
k. Is the quoted price reflective of a market the entity can access?
l. Does the pricing source express disclaimers or limitations on the use of the
quote such that the auditor may be unable or unwilling to rely on the
confirmation?
m. Evaluate the reasonableness of the significant assumptions and document the
basis for our conclusions, considering the nature of the financial instrument and
the fair value financial reporting objective (i.e., the price that would be received
to sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date). The NSPC or a Subject Matter
Resource may be of assistance to the audit engagement team. Consider
performing the following procedures for specific assumptions (if applicable):
i. Risk-free (discount) rate:
(a) Determine whether the method used to derive the yield curve to
arrive at the discount rate is appropriate.

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Deloitte & Touche LLP - Form 1840S (6-11)

(b) Compare the discount rate to appropriate supporting documentation


(i.e., the rate currently available on zero-coupon U.S. government
issues with a remaining term equal to the expected life of the
derivative instrument or embedded feature).
ii. Credit spread:
(a) Determine whether the method used to estimate the credit spread is
appropriate.
(b) Compare the credit spread to appropriate supporting documentation
(i.e., pricing services, credit default swap quotes, credit spreads from
comparable underlying financial instruments).
iii. Prepayment speeds:
(a) Determine whether the method used to estimate the prepayment
speed is appropriate.
(b) Compare prepayment speeds to appropriate supporting
documentation (i.e., those from comparable underlying financial
instruments).
iv. Forward prices:
(a) Determine whether the method used to estimate the forward price (or
forward price curve) is appropriate.
(b) Compare underlying forward price(s) to appropriate supporting
documentation (i.e., pricing services, broker/dealer quotes).
(2) If, as a result of performing Procedure B(2) within this Section, we have concerns
about the reliability or appropriateness of the external pricing information for
financial reporting purposes, request that the entity obtain and provide to us
additional evidence and/or perform alternative procedures to test the fair value
measurement.
(3) Compare the evidence from the external pricing source(s) to the entity’s fair value
measurement used for financial reporting purposes by performing the following:
a. Agree the estimate from the evidence of the price source to the entity’s fair
value used for financial reporting purposes. If differences arise, investigate and
document our conclusions as to whether the differences are misstatements.
b. For financial instruments where it was determined that estimates from more
than one external pricing source were needed to substantiate the fair value,
establish an acceptable tolerance threshold for the purposes of comparing the
multiple prices and document the basis for such threshold. When obtaining and
comparing market prices from multiple sources for the identical financial
instrument, market prices could differ or may be expected to differ based on the
nature of the financial instrument. Determining an acceptable tolerance
threshold requires judgment, and consultation with the NSPC or a Subject
Matter Resource is encouraged.

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Deloitte & Touche LLP - Form 1840S (6-11)

c. If the multiple prices do not vary from each other by more than the acceptable
tolerance threshold, we may conclude that the entity’s fair value measurement
which agrees to one of the prices is reasonable.
d. If the multiple prices vary from each other by more than the acceptable
tolerance threshold, the fair value measurement has not been sufficiently
substantiated. Request that the entity obtain and provide to us additional
evidence and/or perform alternative procedures to test the fair value
measurement such as those in Step B within this Possible Procedure.
(4) Recalculate the unrealized gains or losses based on the results of the fair value
measurement at period-end compared to the prior-year fair value measurement or
transaction price if purchased during the current year.
D. Evaluate results of the tests.

Possible Procedure 5 — Testing Valuation of Derivative Instruments — Level 2


and 3 (ASC 820-10) Inputs, Subsequent or Recent Transactions
A. Consider involving an Internal Fair Value Specialist from Regulatory and Capital Markets
within Deloitte & Touche LLP, the NSPC, or a Financial Instruments and Valuation Subject
Matter Resource if the audit engagement team does not have the requisite expertise
regarding determination of fair value measurements for Level 2 or Level 3 derivatives.
B. For our selections made for testing of the Existence assertion which are derivatives for
which we will test valuation with reference to subsequent or recent transactions, perform
the following procedures:
(1) When using a subsequent or recent event or transaction to substantiate a fair value
measurement, we consider only those events or transactions that reflect circumstances
existing at the balance sheet date. Accordingly, if a market transaction involving a
similar financial instrument occurring near the balance sheet date has been identified,
consider whether the facts and circumstances of the transaction are such that the
transaction value is a relevant reference for the entity’s fair value measurement at the
balance sheet date.
a. Evaluate whether the event or transaction is reflective of the price that would be
received to sell an asset or paid to transfer a liability in an orderly (i.e.,
nondistressed) transaction between market participants at the measurement date.
b. For an event or transaction occurring after the balance sheet date, evaluate if the
event or transaction reflects changes in circumstances occurring after the
balance sheet date and thus does not represent relevant and reliable evidence of
the fair value measurement at the balance sheet date.
c. For an event or transaction occurring before the balance sheet date, evaluate if
circumstances have changed from the transaction date to the balance sheet date
such that the event or transaction does not represent relevant and reliable
evidence of the fair value measurement at the balance sheet date.
(2) If we conclude that an event or transaction near the balance sheet date is
representative of the fair value measurement at the balance sheet date, compare the

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Deloitte & Touche LLP - Form 1840S (6-11)

amount to the fair value measurement at the balance sheet date.


(3) Recalculate the unrealized gains or losses based on the results of the fair value
measurement at period-end compared to the prior-year fair value measurement or
transaction price if purchased during the current year.
C. Evaluate results of the tests.

Possible Procedure 6 — Testing Valuation of Commodity Derivative Instruments


— Level 2 and 3 (ASC 820-10) Inputs, Outside Specialists
A. Consider involving an Internal Fair Value Specialist from Regulatory and Capital Markets
within Deloitte & Touche LLP, the NSPC, or a Financial Instruments and Valuation Subject
Matter Resource if the audit engagement team does not have the requisite expertise
regarding determination of fair value measurements for Level 2 or Level 3 derivatives and
testing of the outside specialists work.
B. For our selections made to test the Existence assertion which are commodity derivatives for
which we intend to test the fair value of the instrument as of the balance sheet date by
utilizing an outside specialist retained by the entity, perform the following audit
procedures. In utilizing the work of an outside specialist to test fair value of the commodity
derivative perform procedures to assess the qualifications, understand the nature of the
work, and evaluate the relationship of the outside specialist to the entity in accordance with
AU 336.
(1) Conclude on the use of the outside specialist’s work and its propriety as audit
evidence in support of our audit procedures.
(2) If practical, recalculate the fair value (consider consulting with an Internal Fair Value
Specialist and/or Subject Matter Resource).
(3) Recalculate the unrealized gains or losses based on the results of the fair value
measurement at period-end compared to the prior-year fair value measurement or
transaction price if purchased during the current year.
C. Evaluate results of the tests.

Possible Procedure 7 — Performing Retrospective Review of Significant


Accounting Estimates Related to Derivative Instruments
A. Perform a retrospective review of significant accounting estimates related to derivative
instruments that existed in the prior year and consider the results of this retrospective
review in evaluating the current-year estimates, including management’s ability to
accurately predict the probability of physical settlement by obtaining documentation that
supports that the contracts have been physically settled and have not “net settled.” If we
identify a possible bias on the part of management in making accounting estimates, we
should evaluate whether circumstances producing such a bias represent a risk of a material
misstatement due to fraud.

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Deloitte & Touche LLP - Form 1840S (6-11)

ACCOUNT BALANCE ASSERTION — OCCURRENCE, CLASSIFICATION, AND


COMPLETENESS OF HEDGING ACTIVITY

Possible Procedure 1 — Test the Appropriateness of the Application of Cash


Flow Hedging (Including Foreign Currency Cash Flow Hedges)
A. For the audit sample of derivatives selected in the testing of the Existence assertion
(including those identified during Possible Procedure 1 for the testing of the Completeness
assertion for which we asked management to revise their listing, if applicable) that are used
as cash flow hedging instruments, perform the following procedures, as applicable:
(1) Verify that the entity has applied cash flow hedge accounting only to those designated
hedging instruments and hedged items for which the formal documentation exists at
the inception of the hedging relationship, noting whether it includes all relevant
details, including all of the following:
a. The date on or period within which the forecasted transaction is expected to
occur.
b. The specific nature of asset or liability involved (if any).
c. For hedges of foreign currency exchange risk, the expected currency amount of
the forecasted transaction (i.e., specification of the exact amount of foreign
currency being hedged).
d. For hedges of risks other than foreign currency exchange risk, the expected
quantity [i.e., specification of the physical quantity (i.e., the number of items or
units of measure) encompassed by the hedged forecasted transaction], and the
current price of a forecasted transaction.
(2) Verify that the entity has applied cash flow hedge accounting only to those hedging
relationships that both at inception of the hedge and on an ongoing basis were
expected to be highly effective in achieving offsetting changes in cash flows
attributable to the hedged risk during the term of the hedge, except for certain swaps
used to modify the interest receipts or payments associated with a recognized
financial asset or liability from one variable rate to another variable rate.
(3) If the entity designated a written option as hedging the variability in cash flows for a
recognized asset or liability or an unrecognized firm commitment, verify that the
combination of the hedged item and the written option provides at least as much
potential for favorable cash flows as exposure to unfavorable cash flows.
(4) If the entity used a hedging instrument to modify the interest receipts or payments
associated with a recognized financial asset or liability from one variable rate to
another variable rate, verify that the hedging instrument meets both of the following
criteria:
a. The hedging instrument must be a link between an existing designated asset (or
group of similar assets) with variable cash flows and an existing designated
liability (or group of similar liabilities) with variable cash flows.
b. The hedging instrument must be highly effective at achieving offsetting cash

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Deloitte & Touche LLP - Form 1840S (6-11)

flows.
(5) If the entity is hedging a forecasted transaction, verify that the forecasted transaction
designated as being hedged is specifically identified as a single transaction or a group
of individual transactions.
(6) If the hedged transaction in a cash flow hedge is a group of individual transactions,
verify that those individual transactions share the same risk exposure for which they
are designated as being hedged (e.g., forecasted purchase and a forecasted sale cannot
both be included in the same group of individual transactions that constitute the
hedged transaction).
(7) If the entity is hedging a forecasted transaction, verify that the occurrence of the
forecasted transaction designated as being hedged is probable by obtaining an
understanding of the process used by management to make its decision, and
considering whether management’s activities corroborate or conflict with its stated
intent. Determine whether management considered the possibility that one of the
parties to the forecasted transaction may default, when making its probability
assessment.
(8) Gather evidence to determine that the occurrence of the forecasted transaction is
probable, and verify that the quantity under the forecasted transaction is greater than
or equal to the quantity being hedged by the hedging instrument (i.e., verify that the
entity is not overhedged in any month). In determining probability, consider (a) the
frequency of similar past transactions, (b) the financial and operational ability of the
entity to carry out the transaction, (c) substantial commitments of resources to a
particular activity, (d) the extent of loss or disruption of operations that could result if
the transaction does not occur, and (e) the likelihood that transactions with
substantially different characteristics might be used to achieve the same business
purpose.
(9) If the entity has designated interest rate risk as the risk being hedged in a cash flow
hedge, verify that the entity has applied cash flow hedge accounting only to those
hedging relationships for which the following conditions are met:
a. The benchmark interest rate being hedged was specifically identified as part of
the designation and documentation at the inception of the hedging relationship.
b. The use of different benchmark interest rates for similar hedges is rare and
justified.
c. In a cash flow hedge of a variable-rate financial asset or liability, either existing
or forecasted, the designated risk being hedged, not the risk of changes in its
cash flows attributable to changes in the specifically identified benchmark
interest rate if the cash flows of the hedged transaction are explicitly based on a
different index.
B. Perform the following additional procedures for foreign currency contracts designated as
cash flow hedges:
(1) Evaluate whether the hedge is properly designated as one of the following: [ASC
815-20-25-28]

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Deloitte & Touche LLP - Form 1840S (6-11)

a. A cash flow hedge of a forecasted transaction, an unrecognized firm


commitment, the forecasted functional-currency-equivalent cash flows
associated with a recognized asset or liability, or a forecasted intercompany
transaction
b. A hedge of a net investment in a foreign operation
(2) For cash flow hedges of the foreign currency exposure to variability in the functional-
currency-equivalent cash flows of a forecasted transaction, an unrecognized firm
commitment, a recognized asset or liability, or a forecasted intercompany transaction,
evaluate whether the entity has applied hedge accounting only to those hedging
relationships for which all of the following conditions are met:
a. The hedging instrument is a derivative instrument (rather than a nonderivative
financial instrument).
b. The entity is hedging the foreign currency exposure to variability in the
functional-currency-equivalent cash flows associated with a forecasted
transaction (e.g., a forecasted export sale to an unaffiliated entity with the price
to be denominated in a foreign currency), a recognized asset or liability, an
unrecognized firm commitment, or a forecasted intercompany transaction (e.g.,
a forecasted sale to a foreign subsidiary or a forecasted royalty from a foreign
subsidiary).
c. For consolidated financial statements, either (1) the operating unit that has the
foreign currency exposure is a party to the hedging instrument or (2) another
member of the consolidated group that has the same functional currency as that
operating unit is a party to the hedging instrument and, if so, there is no
intervening subsidiary with a different functional currency.
d. The hedged transaction is denominated in a currency other than the hedging
unit’s functional currency.
e. All of the criteria for cash flow hedge accounting in paragraphs 28 and 29 of
FASB Statement No. 133, Accounting for Derivative Instruments and Hedging
Activities [ASC 815, Derivatives and Hedging], are met, except for the criterion
in paragraph 29(c) that requires that the forecasted transaction be with a party
external to the reporting entity.
f. If the hedged transaction is a group of individual forecasted foreign-currency-
denominated transactions, a forecasted inflow of a foreign currency and a
forecasted outflow of the foreign currency cannot both be included in the same
group.
g. If the hedged item is a recognized foreign-currency-denominated asset or
liability, all the variability in the hedged item’s functional-currency-equivalent
cash flows is eliminated by the effect of the hedge (e.g., a cash flow hedge
cannot be used with a variable-rate foreign-currency-denominated asset or
liability and a derivative based solely on changes in exchange rates because the
derivative does not eliminate all the variability in the functional currency cash
flows).

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Deloitte & Touche LLP - Form 1840S (6-11)

(3) For hedges of the foreign currency exposure of a net investment in a foreign
operation, verify that the entity has applied hedge accounting only to those hedging
relationships for which all of the following conditions are met: [ASC 815-20-25-58,
25-30(a), and 25-30(b)]
a. The designated hedging instrument is either (a) a derivative instrument or (b) a
nonderivative financial instrument that may give rise to a foreign currency
transaction gain or loss under ASC 830, Foreign Currency Matters.
b. For consolidated financial statements, either (1) the operating unit that has the
foreign currency exposure is a party to the hedging instrument or (2) another
member of the consolidated group that has the same functional currency as that
operating unit is a party to the hedging instrument and, if so, there is no
intervening subsidiary with a different functional currency.
c. The hedged transaction is denominated in a currency other than the hedging
unit’s functional currency.
(4) If the entity is hedging foreign currency risk on an after-tax basis, verify that the
entity has included the portion of the gain or loss on the hedging instrument that
exceeds the loss or gain on the hedged item as an offset to the related tax effects in
the period in which those tax effects are recognized. [ASC 815-25-35-7]

Possible Procedure 2 — Test the Appropriateness of the Application of Fair


Value Hedging (Including Foreign Currency Fair Value Hedges)
A. For the audit sample of derivatives selected in the testing of the Existence assertion that are
used as fair value hedging instruments, verify that the documentation of the hedging
relationship, risk objective, and strategy is in place at the inception of the hedge and is
sufficient to meet the ASC 815 requirements for hedge accounting by determining that the
documentation contains at a minimum:
(1) Designation of the hedged item and how it is consistent with the overall risk
management policy.
(2) Identification of the hedging instrument.
(3) Identification of the risk being hedged.
(4) Assessment of how the instrument is expected to be highly effective in offsetting the
exposure to changes in the hedge item’s fair value attributable to the risk being
hedged at inception and throughout the hedge period.
(5) Description of how effectiveness will be assessed throughout the period of the hedge,
and identification of those items excluded from the measurement of effectiveness
(i.e., identification of methodologies, such as regression analysis, ratio analysis,
cumulative offset, or period-to-period offset that will be used to assess hedge
effectiveness retrospectively and prospectively, and whether certain components of a
hedging derivative’s change in fair value will be excluded from such assessments).
(6) For a fair value hedge of a firm commitment, identification of a reasonable method
for recognizing in earnings the asset or liability representing the gain or loss on the
hedged firm commitment.

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Deloitte & Touche LLP - Form 1840S (6-11)

(7) Documentation of the impact of credit risk on fair value hedge effectiveness
assessments.
B. Using the entity’s documentation, evaluate whether each selection qualifies for hedge
accounting at inception:
(1) Evaluate whether the documentation properly included those items described in Step
A above and that such formal documentation was prepared at the inception of the
hedge.
(2) Evaluate whether the hedging instrument:
a. Is a derivative instrument. [ASC 815-20-25-11]
b. Is designated as hedging an exposure to changes in the fair value of an asset,
liability, or firm commitment or an identified portion thereof that is attributable
to a particular risk. [ASC 815-20-25-11]
(3) Evaluate whether, both at inception of the hedge and on an ongoing basis, the hedging
relationship is expected to be highly effective in achieving offsetting changes in fair
value attributable to the hedged risk during the period that the hedge is designated.
C. For selections in Step A within this Section, perform the following procedures, as
applicable:
(1) If a written option was designated as the hedging instrument, verify that the entity has
applied fair value hedge accounting only when the combination of the hedged item
and the written option provides at least as much potential for gains as a result of a
favorable change in the fair value of the combined instruments as exposure to losses
from an unfavorable change in their combined fair value. [ASC 815-20-25-94]
(2) If the hedging instrument (such as an at-the-money option contract) provides only
one-sided offset of the hedged risk, verify that the increases (or decreases) in the fair
value of the hedging instrument are expected to be highly effective in offsetting the
decreases (or increases) in the fair value of the hedged item.
(3) In respect of the hedged item, verify the following:
a. The hedged item is specifically identified as either all or a specific portion of a
recognized asset or liability or of an unrecognized firm commitment, and verify that
the hedged item is a single asset or liability (or a specific portion thereof) or is a
portfolio of similar assets or a portfolio of similar liabilities (or a specific portion
thereof). [ASC 815-20-25-12]
(4) If the entity aggregated and hedged similar assets or similar liabilities and designated
them in fair value hedges as a hedged item on a portfolio basis, verify that the entity
has applied fair value hedge accounting only to those hedging relationships for which
the following conditions are met: [ASC 815-20-25-12(b)(1)]
a. The individual assets or individual liabilities in the portfolio share the risk
exposure for which they were designated as being hedged.
b. The change in fair value attributable to the hedged risk for each individual item
in the hedged portfolio is expected to respond in a generally proportionate

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Deloitte & Touche LLP - Form 1840S (6-11)

manner to the overall change in fair value of the aggregate portfolio attributable
to the hedged risk. Refer to paragraph 21 (a)(1) of FASB Statement 133 for
additional quantitative guidelines.
(5) If the entity designated as a hedged item in a fair value hedge a specific portion of an
asset or liability (or of a portfolio of similar assets or a portfolio of similar liabilities),
verify that the entity has applied fair value hedge accounting only to those hedging
relationships for which the hedged item is one of the following:
a. A percentage of the entire asset or liability (or of the entire portfolio).
b. One or more selected contractual cash flows (such as the portion of the asset or
liability representing the present value of the interest payments in the first two
years of a four-year debt instrument).
c. A put option or call option (including an interest rate or price cap or an interest
rate or price floor) embedded in an existing asset or liability that is not an
embedded derivative accounted for separately.
d. The residual value in a lessor’s net investment in a direct financing or sales-type
lease. [ASC 815-20-25-12(b)(2)]
(6) Verify that the hedged item presents an exposure to changes in fair value attributable
to the hedged risk that could affect reported earnings (except for an entity that does
not report earnings as a separate caption in a statement of financial performance, such
as a not-for-profit organization). [ASC 815-20-25-12]
(7) Verify that the hedged item is something other than the following: [Paragraph 21(c) of
FASB Statement 133] [ASC 815-20-25-43]
a. An asset or liability that is remeasured with the changes in fair value
attributable to the hedged risk reported currently in earnings.
b. An investment accounted for by the equity method in accordance with the
requirements of APB Opinion No. 18, The Equity Method of Accounting for
Investments in Common Stock. [ASC 323, Investments — Equity Method and
Joint Ventures]
c. A noncontrolling interest in one or more consolidated subsidiaries.
d. An equity investment in a consolidated subsidiary.
e. A firm commitment either to enter into a business combination or to acquire or
dispose of a subsidiary, a noncontrolling interest, or an equity method investee.
f. An equity instrument issued by the entity and classified in stockholders’ equity
in the statement of financial position.
g. A deemed implicit fixed-to-variable swap (or similar instrument) perceived to
be embedded in a host contract with fixed cash flows when the entire asset or
liability is an instrument with variable cash flows.
(8) If the entity is hedging all or a portion of a debt security (or a portfolio of similar debt
securities) that is classified as held-to-maturity in accordance with FASB Statement
No. 115, Accounting for Certain Investments in Debt and Equity Securities [ASC

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Deloitte & Touche LLP - Form 1840S (6-11)

320, Investments — Debt and Equity Securities], verify that the entity has applied fair
value hedge accounting only if the designated risk being hedged is the risk of changes
in its fair value attributable to credit risk, foreign exchange risk, or both. [ASC 825-
20-25-12(d)]
(9) If the entity is hedging an option component of a held-to-maturity security that
permits its prepayment, verify that the entity has applied fair value hedge accounting
only if the designated risk being hedged is the risk of changes in the entire fair value
of that option component. Also, if the hedged item is an option component of a held-
to-maturity security that permits prepayment, verify that the designated risk being
hedged is the risk of changes in the entire fair value of that option component. [ASC
825-20-25-12(d)]
(10) If the entity is hedging a nonfinancial asset or liability (other than a recognized loan
servicing right or a nonfinancial firm commitment with financial components), verify
that the designated risk being hedged is the risk of changes in the fair value of the
entire hedged asset or liability, reflecting its actual location if a physical asset (e.g.,
the price risk of a similar asset in a different location or of a major ingredient may not
be the hedged risk). [ASC 815-20-25-12(e)]
(11) If the hedged item is a financial asset or liability, a recognized loan servicing right, or
a nonfinancial firm commitment with financial components, verify that the entity has
applied fair value hedge accounting only if the designated risk being hedged is either:
a. The risk of changes in the overall fair value of the entire hedged item, or
b. One or more of the following risks:
i. The risk of changes in its fair value attributable to changes in the
designated benchmark interest rate (referred to as “interest rate risk”)
ii. The risk of changes in its fair value attributable to changes in the related
foreign currency exchange rates (referred to as “foreign exchange risk”)
iii. The risk of changes in its fair value attributable to both changes in the
obligor’s creditworthiness and changes in the spread over the benchmark
interest rate with respect to the hedged item’s credit sector at inception of
the hedge (referred to as “credit risk”). [ASC 815-20-25-12 (f)]
(12) If the entity designated interest rate risk as the risk being hedged in a fair value hedge,
verify that the entity has applied fair value hedge accounting only if all of the
following conditions are met: [ASC 815-20-25-6]
a. The benchmark interest rate being hedged was specifically identified as part of
the designation and documentation at the inception of the hedging relationship.
b. The use of different benchmark interest rates for similar hedges is rare and
justified.
c. In calculating the change in the hedged item’s fair value attributable to changes
in the benchmark interest rate, the estimated cash flows used in calculating fair
value are based on all of the contractual cash flows of the entire hedged item.
D. For items in our audit sample for testing the Existence assertion, which are foreign

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Deloitte & Touche LLP - Form 1840S (6-11)

currency fair value hedges, perform the following additional procedures, as applicable:
(1) Evaluate whether the hedge is properly designated as one of the following: [ASC
815-20-25-28]
a. A fair value hedge of an unrecognized firm commitment or a recognized asset
or liability (including an available-for-sale security) (or specific portions
thereof).
b. A cash flow hedge of a forecasted transaction, an unrecognized firm
commitment, the forecasted functional-currency-equivalent cash flows
associated with a recognized asset or liability, or a forecasted intercompany
transaction.
c. A hedge of a net investment in a foreign operation.
(2) For fair value hedges of the foreign currency exposure of an unrecognized firm
commitment (or a specific portion thereof), verify that the entity has applied hedge
accounting only to those hedging relationships for which all of the following
conditions are met: [ASC 815-20-25-30(a) and 25-30(b)]
a. The designated hedging instrument is either (a) a derivative instrument or (b) a
nonderivative financial instrument that may give rise to a foreign currency
transaction gain or loss under ASC 830.
b. The entity is hedging changes in the fair value of an unrecognized firm
commitment, or a specific portion thereof attributable to foreign currency
exchange rates.
c. For consolidated financial statements, either (1) the operating unit that has the
foreign currency exposure is a party to the hedging instrument or (2) another
member of the consolidated group that has the same functional currency as that
operating unit is a party to the hedging instrument and, if so, there is no
intervening subsidiary with a different functional currency.
d. The hedged transaction is denominated in a currency other than the hedging
unit’s functional currency.
(3) For fair value hedges of the foreign currency exposure of a recognized asset or
liability (or a specific portion thereof), verify that the entity has applied hedge
accounting only to those hedging relationships for which all of the following
conditions are met:
a. The designated hedging instrument is a derivative instrument (rather than a
nonderivative financial instrument).
b. The entity is hedging the changes in the fair value of a recognized asset or
liability (or a specific portion thereof) for which a foreign currency transaction
gain or loss is recognized in earnings under ASC 830-20-40-1.
c. All the criteria for fair value hedge accounting in ASC 815-20-25-20 and 25-21
are met.
d. For consolidated financial statements, either (1) the operating unit that has the

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Deloitte & Touche LLP - Form 1840S (6-11)

foreign currency exposure is a party to the hedging instrument or (2) another


member of the consolidated group that has the same functional currency as that
operating unit is a party to the hedging instrument and, if so, there is no
intervening subsidiary with a different functional currency.
e. The hedged transaction is denominated in a currency other than the hedging
unit’s functional currency.
(4) For fair value hedges of the foreign currency exposure of an available-for-sale equity
security, validate that the entity applied hedge accounting only to those hedging
relationships for which all of the following conditions are met:
a. The hedging instrument is a derivative instrument (rather than a nonderivative
financial instrument).
b. The entity is hedging the changes in the fair value of an available-for-sale
equity security attributable to changes in foreign currency exchange rates.
c. All of the criteria for fair value hedge accounting in ASC 815-20-25-20 and
25-21 are met.
(5) For fair value hedges of the foreign currency exposure of an available-for-sale debt
security (or a specific portion thereof), verify that the entity has applied hedge
accounting only to those hedging relationships for which all of the following
conditions are met:
a. The hedging instrument is a derivative instrument (rather than a nonderivative
financial instrument).
b. All of the criteria for fair value hedge accounting in ASC 815-20-25-20 and 25-
21 are met.
c. The entity is hedging the changes in the fair value of an available-for-sale debt
security (or a specific portion thereof) attributable to changes in foreign
currency exchange rates, and
i. For consolidated financial statements, either (1) the operating unit that has
the foreign currency exposure is a party to the hedging instrument or (2)
another member of the consolidated group that has the same functional
currency as that operating unit is a party to the hedging instrument and
there is no intervening subsidiary with a different functional currency.
ii. The hedged transaction is denominated in a currency other than the
hedging unit’s functional currency.
d. The entity is hedging the changes in fair value of an available-for-sale equity
security attributable to changes in foreign exchange rates, and
i. The security is not traded on an exchange (or other established
marketplace) on which trades are denominated in the investor’s functional
currency.
ii. Dividends or other cash flows to holders of the security are all
denominated in the same foreign currency as the currency expected to be

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received upon sale of the security.


(6) For fair value hedges of the foreign currency exposure of an available-for-sale
security (or a specific portion thereof), validate that the entity reported the change in
fair value of the hedged available-for-sale equity security attributable to foreign
exchange risk in earnings (rather than other comprehensive income) to offset the gain
or loss on the hedging instrument. [ASC 815-20-25-37(b)]
(7) Verify that gains and losses on qualifying foreign currency fair value hedges are
accounted for as specified for fair value hedges in ASC 815-25-35-15.
(8) For foreign currency fair value hedges, verify that the entity has recognized the gains
and losses on nonderivative hedging instruments attributable to foreign currency risk
currently in earnings along with the change in the carrying amount of the hedged firm
commitments. [ASC 815-25-35-16]
(9) If the entity is hedging foreign currency risk (i.e., the FASB Statement No. 52,
Foreign Currency Translation, foreign currency transaction gain or loss) on an after-
tax basis, verify that the entity has included the portion of the gain or loss on the
hedging instrument that exceeds the loss or gain on the hedged item as an offset to the
related tax effects in the period in which those tax effects are recognized. [ASC 815-
25-35-7]

ACCOUNT BALANCE ASSERTION — OCCURRENCE, ACCURACY, AND


COMPLETENESS OF HEDGING ACTIVITY

Possible Procedure 1 — Test Inception Gains and Losses


A. Obtain the entity’s documentation for items initially recognized during the current year
including:
(1) An analysis determining whether the transaction price would be expected to be
representative of fair value (i.e., the hypothetical exit price).
(2) Reports that management uses in the inception date gain or loss review process (e.g.,
tracking reports, fair value analyses).
(3) An inception date gain or loss analysis if necessary (e.g., transaction price was not
representative of fair value).
B. Evaluate the entity’s qualitative analysis of whether the transaction price would be
expected to be representative of the fair value of the asset or liability at initial recognition,
considering factors specific to the transaction and the asset or liability.
(1) Verify that the entity has appropriately considered the professional standards in
determining whether the transaction price is representative of fair value at inception.
C. If it was concluded above that the transaction price would not be expected to be
representative of the fair value of the asset or liability at initial recognition, then gain or
loss recognition at the inception date is permitted to equal the difference between the fair
value measurement and the transaction price at the date of inception. The unrealized gain or
loss for the period is therefore equal to the difference between the transaction price and the

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fair value measurement at period-end.


D. If it was concluded above that the transaction price would be expected to be representative
of the fair value of the asset or liability at initial recognition, perform the following:
(1) Agree that initial recognition of asset or liability in an amount equal to the transaction
price, with no gain or loss being recognized at initial recognition.

ACCOUNT BALANCE ASSERTION — OCCURRENCE, ACCURACY,


COMPLETENESS AND CLASSIFICATION OF HEDGING ACTIVITY

Possible Procedure 1 — Test Hedge Effectiveness


A. Test hedge effectiveness for the hedging instruments selected for testing of the Existence
assertion that used the short-cut method, critical-terms-match method or long-haul method
by performing the following procedures, as applicable:
(1) Short-cut method (assume no ineffectiveness)
[Note: Consider consulting with an Internal Fair Value Specialist and/or Subject Matter
Resource when an entity uses the short-cut method, particularly if there is any uncertainty
as to whether its use is appropriate.]
a. If the entity has assumed no ineffectiveness in a hedging relationship of interest
rate risk involving a recognized interest-bearing asset or liability (or a firm
commitment arising on the trade [pricing] date to purchase or issue an interest-
bearing asset or liability, provided that, in the case of the firm commitment, the
trade date of the asset or liability differs from its settlement date due to
generally established conventions in the marketplace in which the transaction is
executed) and an interest rate swap and is applying the short-cut method,
determine that the hedge properly meets all of the conditions for the short-cut
method by performing the following:
i. Verify that the notional amount of the swap matches the principal amount
of the interest-bearing asset or liability being hedged. [ASC 815-20-25-
104(a)]
ii. If the hedging instrument is solely an interest rate swap, verify that the fair
value of that swap at the inception of the hedging relationship is zero, with
one exception. The fair value of the swap may be other than zero at the
inception of the hedging relationship only if the swap was entered into at
the relationship’s inception, the transaction price of the swap was zero in
the entity’s principal market (or most advantageous market), and the
difference between transaction price and fair value is attributable solely to
differing prices within the bid-ask spread between the entry transaction
and a hypothetical exit transaction. [ASC 815-20-25-104(b)]
iii. If the hedging instrument is a compound derivative composed of an
interest rate swap and mirror-image call or put option, verify that the
premium for the mirror-image call or put option is paid or received in the
same manner as the premium on the call or put option embedded in the

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hedged item as discussed in paragraph 68(b) of FASB Statement 133.


[ASC 815-20-25-104(c)]
iv. Verify that the formula for computing net settlements under the interest
rate swap is the same for each net settlement (i.e., verify that the fixed rate
is the same throughout the term, and the variable rate is based on the same
index and includes the same constant adjustment or no adjustment). [ASC
815-20-25-104(d)]
v. Verify that the interest-bearing asset or liability is not prepayable (i.e., able
to be settled by either party prior to its scheduled maturity), except in the
following instances:
(a) An interest-bearing asset or liability that is prepayable solely due to
an embedded call option provided that the hedging instrument is a
compound derivative composed of an interest rate swap and a
mirror-image call option.
(b) An interest-bearing asset or liability that is prepayable solely due to
an embedded put option provided that the hedging instrument is a
compound derivative composed of an interest rate swap and a
mirror-image put option. [ASC 815-20-25-104(e)]
(c) Verify that the index on which the variable leg of the swap is based
matches the benchmark interest rate designated as the interest rate
risk being hedged for that hedging relationship. [ASC 815-20-25-
104(f)]
(d) If there are any other terms in the interest-bearing financial
instruments or interest rate swaps, verify that they are typical of
those instruments and that they do not invalidate the assumption of
no ineffectiveness. [ASC 815-20-25-104(g)]
CASH FLOW HEDGES ONLY
vi. Verify that all interest receipts or payments on the variable-rate asset or
liability during the term of the swap are designated as hedged, and that no
interest payments beyond the term of the swap are designated as hedged.
[ASC 815-20-25-106(a) and 25-106(b)]
vii. Verify that there is no floor or cap on the variable interest rate of the swap
unless the variable-rate asset or liability has a floor or cap. [ASC 815-20-
25-106(c)]
viii. If the variable-rate asset or liability has a floor or cap, verify that the swap
has a floor or cap on the variable interest rate that is comparable to the
floor or cap on the variable-rate asset or liability. [ASC 815-20-25-106(c)]
ix. Verify that the repricing dates match those of the variable-rate asset or
liability. [ASC 815-20-25-106(d)]
b. Verify whether the entity has applied the short-cut method only to fair value
hedges for which an assumption of no ineffectiveness applies for a hedging

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relationship involving an interest rate swap used as a fair value hedge of a fixed-
rate asset or liability. [ASC 815-20-25-102]
c. Verify whether the entity has applied the short-cut method only to cash flow
hedges for which the assumption of no ineffectiveness applies for a hedging
relationship involving an interest rate swap used as a cash flow hedge of interest
receipts on a variable-rate asset (or interest payments on a variable-rate
liability). [ASC 815-30-55-25]
(2) Test critical-terms-match method.
[Note: Consider consulting with an Internal Fair Value Specialist and/or Subject Matter
Resource when an entity uses the critical-terms-match method, particularly if there is any
uncertainty as to whether or not the critical terms exactly match.]
a. Determine if the critical terms of the hedging instrument exactly match the
critical terms of the hedged item:
i. If the critical terms exactly match, a quantitative hedge effectiveness test
need not be performed and, similarly, hedge ineffectiveness need not be
measured. However, verify that the entity updated its analysis of the
critical terms at least quarterly.
ii. If the critical terms do not exactly match, see testing under Step 3, test
hedge effectiveness (long-haul method) below.
(3) Test hedge effectiveness (long-haul method).
a. Determine whether the entity has properly assessed hedge effectiveness in
accordance with its documented policies and that the methods used to assess
effectiveness comply with those included in the entity’s documented polices
(including the risk management strategy) and are performed at least quarterly.
[ASC 815-20-25-80 and ASC 815-25-25-6] Perform the following procedures:
i. Determine that the method used is appropriate.
ii. Obtain the hedge effectiveness analyses and test the assumptions,
underlying data, and calculations.
iii. Evaluate whether the analyses indicate that the hedge was highly effective
throughout the quarterly periods by performing, for example:
(a) If the entity used period-to-period dollar offset analysis, determine
that effectiveness for each three-month period was within a range of
80–125 percent.
(b) If the entity used regression analysis, determine that for each three-
month period r2 was 0.8 or greater and that the slope was between
-0.8 and -1.25. In addition, evaluate the t-statistic and F-statistic to
assess the validity of the linear regression. Consider consulting with
an Internal Fair Value Specialist and/or Subject Matter Resource or
the NSPC.
b. Evaluate whether the entity applied hedge accounting only to hedging

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Deloitte & Touche LLP - Form 1840S (6-11)

relationships for which all of the following conditions related to the assessment
of hedge effectiveness are met:
i. The entity assessed effectiveness for similar hedges in a similar manner or,
if it used different methods for similar hedges, it was able to justify the use
of different methods. [ASC 815-20-25-81]
ii. In defining how hedge effectiveness will be assessed, the entity specified
whether it will include in that assessment all of the gain or loss on a
hedging instrument or exclude all or a part of the hedging instrument’s
time value from the assessment. [ASC 815-20-25-82]
iii. If the entity, in defining how hedge effectiveness will be assessed, has
excluded all or a part of the hedging instrument’s time value from the
assessment of hedge effectiveness and is hedging with an option contract,
it is assessing effectiveness either based on changes in the option’s
intrinsic value or the option’s minimum value (i.e., its intrinsic value plus
the effect of discounting). [ASC 815-20-25-82(a) and 25-82(b)]
iv. If the entity, in defining how hedge effectiveness will be assessed, has
excluded all or a part of the hedging instrument’s time value from the
assessment of hedge effectiveness and is hedging with a forward or futures
contract, it is assessing effectiveness based on changes in the contract’s
fair value attributable to changes in spot prices. [ASC 815-20-25-82(d)]
v. The entity included currently in earnings changes in any excluded
component together with any ineffectiveness that results under the method
defined by the entity of assessing ineffectiveness. [ASC 815-20-25-83]
vi. The entity excludes no other components of a gain or loss on the
designated hedging instrument from the assessment of hedge
effectiveness. [ASC 815-20-25-83]
vii. In assessing the effectiveness of a cash flow hedge, the entity generally
considered the time value of money if significant in the circumstances.
[ASC 815-20-25-120]
c. Verify that the entity has accounted for fair value gains and losses on qualifying,
highly-effective fair value hedges as follows: [ASC 815-25-35-1]
i. Recognize the gain or loss on the hedging instrument currently in
earnings.
ii. Record the gain or loss (i.e., the change in fair value) on the hedged item
attributable to the hedged risk as an adjustment to the carrying amount of
the hedged item and recognize the gain or loss currently in earnings.
d. Verify that the entity has reported the effective portion of the gain or loss on a
derivative designated as a cash flow hedge in other comprehensive income.
[ASC 815-30-25-3]
e. Verify that the entity has reported the ineffective portion of the gain or loss on a
derivative designated as a cash flow hedge in earnings, including the following

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sources of ineffectiveness: [ASC 815-30-25-3]


i. Any hedge ineffectiveness resulting from a difference between the basis of
the hedging instrument and the hedged item or hedged transaction, to the
extent that those bases do not move in tandem. [ASC 815-20-25-77(a)]
ii. Any hedge ineffectiveness resulting from differences in critical terms of
the hedging instrument and the hedged item or hedged transaction, such as
differences in notional amounts, maturities, quantity, location, or delivery
dates. [ASC 815-20-25-77(b)]
iii. Any hedge ineffectiveness resulting from a change in the fair value of a
derivative hedging instrument that is attributable to a change in the
counterparty’s creditworthiness. [ASC 815-20-25-77(c)]

ACCOUNT BALANCE ASSERTION — OCCURRENCE AND ACCURACY OF


HEDGING ACTIVITY

Possible Procedure 1 — Test Gains and Losses on Settled Contracts


A. Apply an appropriate technique (i.e., ACL or another method if more efficient) to make an
audit sample of the realized gain or loss on derivative contracts.
B. For each settlement selected, perform the following:
(1) Obtain the documentation supporting the settlement of the contract and agree the
amount(s) paid.
(2) Recompute the gain or loss with reference to the settlement amount and the recorded
balance.
(3) For contracts where hedge accounting has not been applied, agree the gain or loss to
the general ledger.

ACCOUNT BALANCE ASSERTION — ACCURACY AND CLASSIFICATION OF


HEDGING ACTIVITY

Possible Procedure 1 — Test Hedging Activity


A. For selections made in order to test the Existence assertion, perform the following:
(1) Verify that the entity has adjusted its accumulated other comprehensive income
balance associated with the hedged transaction to the lesser (in absolute amounts) of
(a) the cumulative gain or loss on the derivative from inception of the hedge less (1)
the excluded component discussed in paragraph 30(a) of FASB Statement 133 [ASC
815-30-35-3] and (2) the derivative’s gains or losses previously reclassified from
accumulated other comprehensive income into earnings, or (b) the portion of the
cumulative gain or loss on the derivative necessary to offset the cumulative change in
expected future cash flows on the hedged transaction from inception of the hedge less
the derivative’s gains or losses previously reclassified into earnings from other
accumulated other comprehensive income. [ASC 815-30-35-3(b)]

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Deloitte & Touche LLP - Form 1840S (6-11)

a. Verify the entity’s adjustment of accumulated other comprehensive income


incorporated recognition in other comprehensive income of part or all of the
gain or loss on the hedging derivative, as necessary.
b. Verify the entity recognized a gain or loss in earnings, as necessary, for any
remaining gain or loss on the hedging derivative or to adjust other
comprehensive income to the balance.
(2) In a cash flow hedge of the variability of the functional-currency-equivalent cash
flows for a recognized foreign-currency-denominated asset or liability that is
remeasured at spot exchange rates under paragraph 15 of FASB Statement 52, verify
that the entity has reclassified the following: [ASC 815-30-35-3(e)]
a. An amount “that will offset the related transaction gain or loss arising from that
remeasurement each period” from other comprehensive income to earnings if (i)
a nonoption-based contract is the hedging instrument and (ii) the assessment of
effectiveness and measurement of ineffectiveness are based on total changes in
the nonoption-based instrument’s cash flows.
b. An amount to or from other comprehensive income with respect to the changes
in the underlying that result in a change in the hedging option’s intrinsic value if
an option contract is the hedging instrument in a hedge to provide only one-
sided offset against the hedged foreign exchange risk.
c. An amount that adjusts earnings for the amortization of the cost of the option on
a rational basis from other comprehensive income to earnings if the assessment
of effectiveness and measurement of ineffectiveness are based on total changes
in the option contract’s cash flows (i.e., the assessment includes the hedging
instrument’s entire change in fair value, its entire gain or loss).
(3) Verify that the entity has reclassified amounts from accumulated other comprehensive
income into earnings in the same period or periods during which the hedged
forecasted transaction affects earnings (e.g., when a forecasted sale actually occurs).
For example, “[i]f the hedged transaction results in the acquisition of an asset or the
incurrence of a liability, the gains and losses in accumulated other comprehensive
income shall be reclassified into earnings in the same period or periods during which
the asset acquired or liability incurred affects earnings (such as in the periods that
depreciation expense, interest expense, or cost of sales is recognized).” [ASC 815-30-
35-39]
(4) If the entity expects that “continued reporting of a loss in accumulated other
comprehensive income would lead to recognizing a net loss on the combination of the
hedging instrument and the hedged transaction (and related asset acquired or liability
incurred) in one or more future periods, [verify that the entity has reclassified a loss
immediately] into earnings for the amount that is not expected to be recovered.”
[ASC 815-30-35-40] “For example, a loss shall be reported in earnings for a
derivative that is designated as hedging a forecasted purchase of inventory to the
extent that the cost basis of the inventory plus the related amount reported in
accumulated other comprehensive income exceeds the amount expected to be
recovered through sales of that inventory.” [ASC 815-30-35-41]

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(5) Make inquiries of management and corroborate as necessary, to verify that the entity
has prospectively discontinued hedge accounting for any existing cash flow hedge if
any of the following occurred: [ASC 815-30-40-1]
a. Any of the qualifying criteria for a cash flow hedge were no longer met.
b. The derivative expired or was sold, terminated, or exercised.
c. The entity removed the designation of the cash flow hedge.
(6) If the entity discontinued hedge accounting for any existing cash flow hedge, verify
that the entity retained any net gain or loss in accumulated other comprehensive
income and reclassified that net gain or loss into earnings only when the forecasted
transaction affected earnings or it became probable the forecasted transaction will not
occur. [ASC 815-30-40-2]
(7) If the entity discontinued a cash flow hedge because it is probable that the original
forecasted transaction would not occur at the end of the originally specified period or
within an additional two-month period thereafter (and the hedged forecasted
transaction also does not qualify for the exception in paragraph 33 of FASB
Statement 133 [ASC 815] for rare cases where the existence of extenuating
circumstances related to the nature of the forecasted transaction and outside the
control or influence of the entity causes the forecasted transaction to be probable of
occurring on a date that is beyond the additional two-month period), verify that the
entity has reclassified the net gain or loss in accumulated other comprehensive
income associated with the hedge immediately into earnings. [ASC 815-30-40-4]
(8) When hedging an anticipated transaction in a cash flow hedging relationship, ensure
the hedged item is fair valued similar to the hedge for assessing and/or measuring
effectiveness under the dollar-offset method. Independently obtain verification of the
forward prices.

ACCOUNT BALANCE ASSERTION — CUTOFF OF DERIVATIVES

Possible Procedure 1 — Test Cutoff of Derivative Instruments


A. Apply an appropriate technique (i.e., ACL or another method if more efficient) to make an
audit sample of (1) broker advices representing transactions that occurred in the [x]-day
period prior to year-end, and (2) broker advices in the [x]-day period after year end.
(1) Determine that the transactions and related gains or losses at inception were recorded
in the correct period.

Possible Procedure 2 — Test Cutoff of Gains or Losses on Settled Contracts


A. Apply an appropriate technique (i.e., ACL or another method if more efficient) to make an
audit sample of settlements that occurred in the [x]-day period prior to year end, and in the
[x]-day period after year-end.
(1) Determine that the transactions were recorded in the correct period.

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Deloitte & Touche LLP - Form 1840S (6-11)

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF


DERIVATIVE INSTRUMENTS

Possible Procedure 1 — Test Entities Rights and Obligations Related to


Derivative Instruments
A. Validate entity’s right and/or obligation under the terms of derivative instruments through
confirmation of open contracts by performing the following:
(1) Prepare, or have the entity prepare, confirmation requests for significant contact terms
on a contract-by-contract basis. Mail the confirmation requests under our control,
determine that the requests are properly addressed (i.e., obtain audit evidence about
the accuracy and completeness of addresses provided by the entity), and request that
all replies be sent directly to our office.
(2) Send second requests for nonreplies.
(3) Compare confirmation replies to the entity’s schedule(s) to validate existence of
derivative instruments and therefore related rights and obligations.
(4) Trace nonreplies to statements sent from the counterparty or broker.

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PREPAID EXPENSES

ACCOUNT BALANCE ASSERTION — EXISTENCE OF PREPAID EXPENSES

Possible Procedure 1 — Perform Test of Details on Prepaid Expenses


A. Obtain the schedule of prepaid expense accounts and the reconciliation of the schedule to
the general ledger. Agree applicable amounts from the prepaid expense accounts schedule
and reconciliation to the general ledger and trace significant reconciling items, if any, to
supporting documents.
B. Make an audit sample of prepaid expenses. Obtain reconciliations of the selected accounts
to the general ledger and a rollforward from origination to period-end. For each selection,
perform the following:
(1) Trace the recorded costs of the selected item to supporting documents (e.g., vendor
invoices, lease agreements).
(2) Examine the supporting documentation and verify that cost/expense associated with
prepaid asset relates to a future period.
(3) Trace the original and subsequent payments to bank statements. If payments were not
made in the current year, agree beginning balance to prior year’s working papers.

Possible Procedure 2 — Perform Substantive Analytical Procedures to Test


Prepaid Expenses
A. Perform substantive analytical procedures to test prepaid expense period-end balance.
(1) Consider using ACL (or another method if more efficient) to develop expectations of
prepaid expenses using information such as prior-year prepaid expenses, current-year
amortization, additions (new rental agreements and/or equipment leases, insurance
contracts requiring full or partial advance payments), and timing of payments at the
prior year-end and current period-end.
(2) Use ACL (or another method if more efficient) to disaggregate both the data used to
build the expectations and the various recorded prepaid expense balances at a level of
detail sufficient to enable us to obtain the desired level of assurance based on a
comparison of amounts.
(3) Analyze changes in prepaid expense categories during the period and consider their
reasonableness in view of historic and current information, such as increased
productivity, business plans, etc.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

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Possible Procedure 3 — Using Analytical Procedures and/or Tests of Details to


Update Existence Tests Performed at an Interim Date
A. Make inquiries of the entity’s personnel knowledgeable of prepaid expenses recorded at the
interim date regarding their knowledge of any changes in facts or circumstances in the
intervening period that might have a significant impact on the year-end balance. Perform
one of the following:
B. Obtain and review the schedules of prepaid expenses as of year-end and:

(1) Perform substantive analytical procedures to test the account balance at the end of the
year.

a. Develop expectations of the ending account balance based on the change in the
intervening period considering factors identified during the interim test as well
as those identified during inquires made.

b. Determine threshold.

c. Compare the expectation to the recorded amount and identify any differences.
For any difference that is more than the threshold, obtain, quantify, and
corroborate explanations for the difference by performing further analysis or
inquiry and examining supporting documents. Explanations need to be sought
for the full amount of the difference, not just for the part that exceeds the
threshold.

And/or:

(2) Perform test of details on account balance change in the intervening period (i.e., from
the interim test date to the balance sheet date) by examining activity within the account
balance.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


PREPAID EXPENSES

Possible Procedure 1 — Perform Test of Details on Prepaid Expenses


A. For selections made in Possible Procedure 1 for the testing of the Existence assertion,
perform the following:

(1) Recompute the ending balance.

(2) Determine that expectations of future benefits are reasonable.

Possible Procedure 2 — Perform Substantive Analytical Procedures to Test


Prepaid Expenses
A. Perform substantive analytical procedures to test prepaid expense period-end balance.
(1) Consider using ACL (or another method if more efficient) to develop expectations of

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prepaid expenses using information such as prior-year prepaid expenses, current-year


amortization, additions (new rental agreements and/or equipment leases insurance
contracts requiring full or partial advance payments), and timing of payments at the
prior year-end and current period-end.
(2) Use ACL (or another method if more efficient) to disaggregate both the data used to
build the expectations and the various recorded prepaid expense balances at a level of
detail sufficient to enable us to obtain the desired level of assurance based on a
comparison of amounts.
(3) Analyze changes in prepaid expense categories during the period and consider their
reasonableness in view of historic and current information, such as increased
productivity, business plans, etc.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF PREPAID


EXPENSES

Possible Procedure 1 — Perform Test of Details on Prepaid Expenses


A. Obtain the schedule of prepaid expense accounts and the reconciliation of the schedule to
the general ledger. Agree applicable amounts from the prepaid expense accounts schedule
and reconciliation to the general ledger and trace significant reconciling items, if any, to
supporting documents.
B. Make an audit sample of prepaid expenses. Obtain reconciliations of the selected accounts
to the general ledger and a rollforward from origination to period-end. For each selection,
perform the following:
(1) Trace the recorded costs of the selected item to supporting documents (e.g., vendor
invoices, lease agreements).
(2) Examine the supporting documentation and verify that cost/expense associated with
prepaid asset relates to a future period.
(3) Trace the original and subsequent payments to bank statements. If payments were not
made in the current year, agree beginning balance to prior year’s working papers.

Possible Procedure 2 — Perform Substantive Analytical Procedures to Test


Prepaid Expenses

A. Perform substantive analytical procedures to test prepaid expense period-end balance.

(1) Consider using ACL (or another method if more efficient) to develop expectations of
prepaid expenses using information such as prior-year prepaid expenses, current-year

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amortization, additions (new rental agreements and/or equipment leases insurance


contracts requiring full or partial advance payments), and timing of payments at the
prior year-end and current period-end.

(2) Use ACL (or another method if more efficient) to disaggregate both the data used to
build the expectations and the various recorded prepaid expense balances at a level of
detail sufficient to enable us to obtain the desired level of assurance based on a
comparison of amounts.

(3) Analyze changes in prepaid expense categories during the period and consider their
reasonableness in view of historic and current information, such as increased
productivity, business plans, etc.

(4) Determine the threshold.

(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF PREPAID EXPENSES

Possible Procedure 1 — Perform Substantive Analytical Procedures to Test


Prepaid Expenses

A. Perform substantive analytical procedures to test prepaid expense period-end balance.

(1) Consider using ACL (or another method if more efficient) to develop expectations of
prepaid expenses using information such as prior-year prepaid expenses, current-year
amortization, additions (new rental agreements and/or equipment leases insurance
contracts requiring full or partial advance payments), and timing of payments at the
prior year-end and current period-end.

(2) Use ACL (or another method if more efficient) to disaggregate both the data used to
build the expectations and the various recorded prepaid expense balances at a level of
detail sufficient to enable us to obtain the desired level of assurance based on a
comparison of amounts.

(3) Analyze changes in prepaid expense categories during the period and consider their
reasonableness in view of historic and current information, such as increased
productivity, business plans, etc.

(4) Determine the threshold.

(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and

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examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

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ACCOUNTS RECEIVABLE

ACCOUNT BALANCE ASSERTION — EXISTENCE OF RECEIVABLES

Possible Procedure 1 — Confirm Accounts Receivable 4


A. Obtain the receivables trial balance (accounts receivable aging) and the reconciliation of
the receivables trial balance (accounts receivable aging) to the general ledger.
(1) Agree applicable amounts from the receivables trial balance (accounts receivable
aging) and reconciliation to the general ledger and trace significant reconciling items,
if any, to supporting documents.
B. Make an audit sample of either customer balances or open invoices from the receivables
trial balance (accounts receivable aging). For each selection, perform the following:
(1) Prepare, or have the entity prepare, confirmation requests for the balances or invoices
selected. On the confirmation, include outstanding balance, terms of sale, a
confirmation that delivery has occurred or services have been rendered, and a
confirmation that there are no side-agreements that would alter the substance of the
sales agreement. Mail the confirmation requests under our control, determine that the
requests are properly addressed (i.e., obtain audit evidence about the accuracy and
completeness of addresses provided by the entity), and request that all replies be sent
directly to our office.
(2) Send second requests for nonreplies.
(3) Compare replies to requests. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.
(4) Trace nonreplies to subsequent cash receipts. Trace unpaid nonreplies to shipping
documents, sales invoices and the final sales contract, and to customer
correspondence, if any.
(5) For those nonreplies for which supporting documentation cannot be located and no
other acceptable alternative evidence can be found:
a. Consider the selected items to have misstatements equal to the book value of the
unsupported amounts.
b. Consider whether the reason for our inability to obtain supporting
documentation has implications related to assessing risks of material
misstatement due to fraud, our planned level of control assurance, or our degree
of reliance on management’s representations.

Possible Procedure 2 — Tracing Accounts Receivable to Subsequent Cash


Receipts
Testing subsequent receipts is an alternative procedure when confirmations are not returned by
customers. If this test will be a primary test in lieu of sending confirmations (i.e., Possible
Procedure 1), document the rationale for not sending confirmations in accordance with U.S.
AAM G620.2b.

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A. Obtain the receivables trial balance (accounts receivable aging) and the reconciliation of
the receivables trial balance (accounts receivable aging) to the general ledger.
(1) Agree applicable amounts from the receivables trial balance (accounts receivable
aging) and reconciliation to the general ledger and trace significant reconciling items,
if any, to supporting documents.
a. Make an audit sample of either customer balances or open invoices from the
receivables trial balance (accounts receivable aging). For each selection,
perform the following:
i. Trace to subsequent cash receipts. For those selections where cash has not
been received, trace unpaid amounts to shipping documents, sales invoices
and the final sales contract, and to customer correspondence, if any.
ii. For those selections for which supporting documentation cannot be
located and no other acceptable alternative evidence can be found:
(a) Consider whether the reason for our inability to obtain supporting
documentation has implications related to assessing risks of material
misstatement due to fraud, our planned level of control assurance, or
our degree of reliance on management’s representations.

Possible Procedure 3 — Using Analytical Procedures or Tests of Details to


Update Existence Tests Performed at an Interim Date
A. Inquire into any significant disputed receivables balances at the balance sheet date.
Investigate as necessary.
B. Obtain the receivables trial balance (accounts receivable aging) as of the balance sheet date
and the reconciliation of the receivables trial balance (accounts receivable aging) to the
general ledger.
(1) Agree applicable amounts from the receivables trial balance (accounts receivable
aging) and reconciliation to the general ledger and trace significant reconciling items,
if any, to supporting documents.
C. For individual accounts that have increased by an amount more than performance
materiality (including new accounts larger than PM) since the interim testing date, trace
year-end balances to subsequent cash receipts records. Trace unpaid balances to shipping
documents, sales invoices, and final sales contracts or confirm them with the customers.
Perform one of the following:
D. Perform substantive analytical procedures to test the receivables balance at year-end by
performing the following:
(1) Develop an expectation of the receivables amount at the balance sheet date using
appropriate data such as the following:
 Prior-period receivable balances.
 Monthly amounts of sales receipts, write-offs, recoveries, and credit notes in the
intervening period from the interim testing date to the balance sheet date

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compared to such monthly amounts in prior years and in the current year prior to
the interim testing date.
(2) Disaggregate both the data used to build the expectations and the various recorded
accounts receivable balances at a level of detail sufficient to enable us to identify
material misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded balance and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just that part that exceeds the threshold.
And/or:
E. Obtain a reconciliation of the interim receivables balance to the amount as of the year-end
balance sheet date. Test the mathematical accuracy of the reconciliation and perform the
following procedures on the reconciling items:
(1) Agree sales totals to sales journals.
(2) Agree receipts totals to cash receipts journals.

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(3) Examine supporting documents to test other significant entries.


F. Make an audit sample of entries to sales and cash receipt journals in the intervening period
between the interim testing date and the year-end balance sheet date to test the account
balance change in the intervening period.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


ACCOUNTS RECEIVABLE

Possible Procedure 1 — Testing Entity’s Methodology for Establishing


Allowances
A. Obtain a rollforward schedule of the allowance for doubtful accounts.
(1) Test the summarization of the schedule.
(2) Trace the ending balance to the general ledger.
B. Understand, document, and evaluate the reasonableness of the methods and assumptions
used by management to estimate the allowances for doubtful accounts and sales returns.
C. If management’s methods and assumptions were reasonable, test the accuracy and
completeness of the data used by management by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures may include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
D. Identify and obtain audit evidence to support the key assumptions underlying the estimate.
E. In instances when the audit evidence is inconsistent among differing sources, perform
additional audit procedures to resolve the inconsistency.
F. Using the appropriate data, assumptions, and methodology, recompute the allowance for
doubtful accounts.

Possible Procedure 2 — Developing Independent Expectation of Allowances


A. Develop a point estimate or range. The following factors may be applicable when
developing a point estimate or range for the allowance for doubtful accounts: accuracy of
aging categories in aged trial balance; collectability of large receivables accounts;
collectability of significant overdue accounts; trend in number of days’ sales in receivables;
trend in the allowance as a percentage of sales and receivables; trend in bad debt expense

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as a percentage of sales; collections, write-offs, and recoveries after year-end; and payment
history of customers with doubtful accounts. The additional following factors may be
applicable for developing an independent estimate of the allowance for sales returns: the
standard entity policy for returns, specific language in master agreements with major
customers/classes of major customers, historical return rates, economic environment
impacting customers, and whether the products sold were short-dated stock (near
expiration).
B. When developing a point estimate, obtain audit evidence to support that the data used to
make our point estimate or range is independent and reliable and, if we are using
information produced by the entity, that it is accurate and complete.
C. When using information that is produced by the entity, obtain audit evidence about the
accuracy and completeness of the data by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures ordinarily include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
D. In instances when the audit evidence to be used in forming our expectations is inconsistent
among differing sources, perform additional audit procedures to resolve the inconsistency.
E. Compare the recorded amount(s) to our point estimate or range and evaluate any
differences. When a point estimate has been developed, the difference between our point
estimate and the recorded estimate constitutes a misstatement. When a range provides
sufficient appropriate audit evidence and the recorded estimate lies outside the range, the
misstatement is no less than the difference between the recorded amount and the nearest
point in the range.

Possible Procedure 3 — Performing Retrospective Review of Significant


Accounting Estimates Related to Accounts Receivable
A. Perform a retrospective review of significant accounting estimates related to accounts
receivable of the prior year and consider the results of this retrospective review in
evaluating the current-year estimates. If we identify a possible bias on the part of
management in making accounting estimates, we should evaluate whether circumstances
producing such a bias represent a risk of a material misstatement due to fraud.

Possible Procedure 4 — Testing Valuation of Foreign Currency Receivables


A. Inquire about and consider other available evidence, if any, to identify foreign customers

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with which sales were transacted in foreign currencies. Identify receivables with such
customers. Identify applicable exchange rates and agree them to an independent source.
Recompute foreign currency receivable amounts in the reporting currency.
B. Determine the impact of foreign currency hedging contracts or forward cover, if any, on the
recorded balance of foreign currency receivables.
C. Trace currency translation adjustments to the general ledger.

Possible Procedure 5 — Testing Valuation of Insurance Receivables


A. Obtain the insurance contracts for insurance receivables (e.g., asbestos insurance
receivable) and determine if the amount recorded is in accordance with the insurance
contract.
B. For insurance receivables recorded, consider the creditworthiness of the insurance
company in determining the amount recorded.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF


ACCOUNTS RECEIVABLE

Possible Procedure 1 — Confirm Accounts Receivable


A. Obtain the receivables trial balance (accounts receivable aging) and the reconciliation of
the receivables trial balance (accounts receivable aging) to the general ledger.
(1) Agree applicable amounts from the receivables trial balance (accounts receivable
aging) and reconciliation to the general ledger and trace significant reconciling items,
if any, to supporting documents.
B. Make an audit sample of either customer balances or open invoices from the receivables
trial balance (accounts receivable aging). For each selection, perform the following:
(1) Prepare, or have the entity prepare, confirmation requests for the balances or invoices
selected. On the confirmation, include outstanding balance, terms of sale, a
confirmation that delivery has occurred or services have been rendered, and a
confirmation that there are no side-agreements that would alter the substance of the
sales agreement. Mail the confirmation requests under our control, determine that the
requests are properly addressed (i.e., obtain audit evidence about the accuracy and
completeness of addresses provided by the entity), and request that all replies be sent
directly to our office.
(2) Send second requests for nonreplies.
(3) Compare replies to requests. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.
(4) Trace nonreplies to subsequent cash receipts. Trace unpaid nonreplies to shipping
documents, sales invoices and the final sales contract, and to customer
correspondence, if any.
(5) For those nonreplies for which supporting documentation cannot be located and no
other acceptable alternative evidence can be found:

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Deloitte & Touche LLP - Form 1840S (6-11)

a. Consider the selected items to have misstatements equal to the book value of the
unsupported amounts.
b. Consider whether the reason for our inability to obtain supporting
documentation has implications related to assessing risks of material
misstatement due to fraud, our planned level of control assurance, or our degree
of reliance on management’s representations.

Possible Procedure 2 — Management Inquiry


A. Inquire of management as to the existence of any factoring arrangements or agreements to
collateralize working capital lines of credit with receivables.

Possible Procedure 3 — Examination of Bank Statements and Reconciliations


A. Examine a sample of bank statements and reconciliations for large, unusual items which
could indicate the existence of a factoring arrangement.

Possible Procedure 4 — Review the Minutes of the Board of Director Meetings


A. Review the minutes of the board of director meetings for evidence of factoring
arrangements.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF ACCOUNTS


RECEIVABLE

Possible Procedure 1 — Confirm Accounts Receivable


A. For confirmations sent in Possible Procedure 1 for testing of the Existence assertion above,
rather than requesting a confirmation of a specific invoice amount or customer account
balance, leave amount/balance blank and request customer to fill in amount/balance.

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INVENTORY

ACCOUNT BALANCE ASSERTION — EXISTENCE OF INVENTORY

Possible Procedure 1 — Observe and Test-Count Inventories 5


A. Determine the location of significant inventories, including third-party locations, and
discuss the timing and method of inventory verification with the entity. Assess the
adequacy of the methods to be used. If there are multiple locations, determine those at
which we will observe inventories and perform test counts.
B. On the date of our physical-inventory observation, tour the entity’s facilities to identify any
deficiencies of the count process.
C. Obtain all count sheets and make an audit sample of items from the count sheets.
D. Perform test counts of inventories by performing the following:
(1) Trace and agree our test counts to the count sheets.
(2) Resolve discrepancies promptly, if applicable, based on supporting documents and/or
recounts of the items, and note the disposition of such discrepancies.
(3) Test cutoff of inventory at the physical inventory date.
(4) Inquire of obsolete, slow moving, or excess inventory.
E. If the entity’s physical inventory is not held on the balance sheet date, perform audit
procedures on intervening transactions (e.g., rolling forward or back to the balance sheet
date).
F. Obtain the final, priced inventory compilation and perform the following: [Note: The
compilation should reflect the quantities counted at the physical observation date and/or
confirmed for inventory owned by the entity but held by others.]
(1) Test the summarization and the reconciliation of the total to the general ledger. Trace
significant reconciling items, if any, to supporting documents.
(2) Trace quantities of items test counted or confirmed by us on the physical observation
date to the compilation. Reconcile any discrepancies based on supporting documents.
(3) For sites visited by us compare the compilation to the record of count documents
obtained on the physical observation date. Obtain and corroborate explanations for
any added items.
G. Make an audit sample of items from the final, priced inventory compilation. For the items
selected trace the quantities to the original count documents.

Possible Procedure 2 — Perform Alternative Procedures for Inventories Owned


by the Entity but Held by Others
A. If it is not practicable to observe and count inventories owned by the entity but held by
others:

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(1) Prepare, or have the entity prepare, the confirmation requests for inventories owned
by the entity but held by others as of the balance sheet date.
(2) Prepare second requests for nonreplies.
(3) Compare replies to requests. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.
B. Consider whether alternative audit procedures provide sufficient appropriate audit evidence
of existence and condition to conclude that we do not need to make reference in our audit
report to a scope limitation.

Possible Procedure 3 — Using Analytical Procedures and/or Tests of Details to


Update Existence Tests Performed at and Interim Date
A. Make inquiries of warehouse and operations management regarding any of the following:
unusual inventory shipments, receipts, or adjustments; changes in locations used to store
off-site inventory; and other relevant changes to inventory levels during the intervening
period.
B. Obtain the inventory aging, and the reconciliation of the inventory aging to the general
ledger. Agree applicable amounts from the inventory aging and reconciliation to the general
ledger and trace significant reconciling items, if any, to supporting documents.
C. Perform substantive analytical procedures to test the year-end account balance.
(1) Develop expectations of the year-end account balance by considering factors
identified during the interim test as well as changes in facts or circumstances during
the intervening period identified through inquires.
(2) Determine threshold.
(3) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.
And/or
D. Perform test of details on account balance change in the intervening period (i.e., from the
interim test date to the balance sheet date) by examining activity within the account
balance.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


INVENTORY

Possible Procedure 1 — Test the Final Inventory Compilation


A. Obtain the final, priced inventory compilation. [Note: The compilation should reflect the
quantities counted at the physical observation date and/or confirmed for inventory owned
by the entity but held by others.]

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B. Obtain an understanding of the elements that make up the unit costs of inventory, make an
audit sample or use the selections made for inventory test counts and perform the
following:.
(1) If the cost of inventories are determined using FIFO, verify unit costs by examining
the most recent purchase invoices showing quantities equal to the quantities used to
determine final FIFO costs, and recompute the costs.
(2) If the cost of inventories is determined by using average costing, trace prices used to
build up the average cost to purchase invoices in the latest period.
(3) Verify that the unit costs includes:
a. Acquisition and production costs.
b. Overhead expenses that are clearly related to inventory production.
(4) Verify that the unit costs excludes:
a. Selling expenses.
b. Abnormal freight.
c. Abnormal handling costs.
d. Amounts of wasted materials (spoilage).
[Note: Generally, general and administrative expenses, except for the portion of such
expenses that are clearly related to inventory production are excluded from inventory cost.]
(5) Test the mathematical accuracy of the extensions and footings.

Possible Procedure 2 — Perform Procedures to Test Standard Costing


A. Ascertain and document the entity’s process for establishing standard costs. Specifically
address:
(1) Which products and inventory items are valued using standard costing
(2) How frequently costs are revised
(3) Whether the basis of calculating standard costs is consistent with the basis used in
prior years
(4) What cost data is used to set standards
(5) What other factors are considered in building the standards (e.g., inflation, capacity
level, efficiency targets)
(6) How price and volume variances from standard costs are recorded in the accounting
records
(7) What review procedures are followed to identify variances which should be excluded
from the inventory valuation (e.g., excess material usage, labor stoppages).
B. Make an audit sample of inventory items.
(1) For each item selected:

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Deloitte & Touche LLP - Form 1840S (6-11)

a. If there have been no significant changes in the entity’s business, and the prior-
year standard costing methodology was deemed reasonable and reliable,
compare the current-year standard cost to the prior-year standard cost. Discuss
significant differences with management.
b. Verify materials standard cost using recent purchase invoices.
c. Review labor and overhead components of standard cost for reasonableness
considering the entity’s basis for allocation.
C. Review the standard cost file (or request the entity to run an edit report) to identify unusual
relationships, such as overhead cost with no labor cost, labor or overhead cost with no
material cost, or current-year standard cost significantly greater than prior-year standard
cost.
(1) Verify that the entity has updated its standard cost file on a basis that is consistent
within the industry in which it operates, and assess the timing of the update for
reasonableness.
D. Obtain the entity’s capitalized variance computation and perform the following:
(1) Identify variances that significantly affect inventory valuation.
(2) Verify clerical accuracy of capitalization calculation.
(3) Review the capitalization calculation for reasonableness. Consider the effect of
changes in standard costs.
(4) Agree capitalized variances to the general ledger.

Possible Procedure 3 — Test Market Valuation Reserves


A. Obtain a schedule of the inventory market valuation reserve (if market is lower than cost)
showing beginning and ending balances, write-offs, and provisions.
(1) Test the summarization of the schedule.
(2) Trace the ending balance and the amount of the current-year provision to the general
ledger.
B. Evaluate the reasonableness of the methods and assumptions management used to estimate
the reserve.
C. If market is lower than cost, and management has not established a market valuation
reserve, determine if either:
(1) The estimated sales value, reduced by the costs of completion and disposal, is lower
than the cost, in which case inventory should be stated at the net realizable value, or
(2) Evidence indicates that the cost will be recovered with an approximately normal
profit upon sale in the ordinary course of business, in which case, no loss should be
recognized even through replacement or reproduction costs are lower.
D. Evaluate the reasonableness of the methods and assumptions used to value the inventory.
E. If management’s methods and assumptions were reasonable, test the data and assumptions
underlying the estimate, and recompute the estimate — see Possible Procedure 5.

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F. If management’s methods and assumptions were NOT reasonable, develop a point estimate
or range. Compare our point estimate or range with the recorded estimate and determine
whether the recorded estimate is reasonable — see Possible Procedure 6. The following
factors may be applicable when developing an independent estimate: market value of
specific items that are obsolete, defective, held in quantities excessive in relation to
demand, or otherwise devalued; inventory turnover; trend in gross margins; trend in sales;
trend in quantities on hand; disposition of prior-year obsolete items; ratio of inventory to
assets; large capitalized variances; and purchase or sales commitments.
G. Inquire as to whether any sales incentives have been offered that will result in a loss on sale
of the product (e.g., hold discussions with entity personnel outside the accounting
department). Determine that inventory related to such products has been evaluated for
impairment and was separately written down or appropriately considered in the
determination of the reserve by performing the following:
(1) If the inventory has been separately written down, obtain management’s impairment
analysis and evaluate the reasonableness of the methods and assumptions used to
determine the impairment loss. If management’s methods and assumptions were
reasonable, test the data and assumptions underlying the impairment analysis, and
recompute the impairment loss. If management’s methods are NOT reasonable,
develop an independent estimate — see Possible Procedures 5 and 6.

Possible Procedure 4 — Test Allocations of Labor and Overhead When Standard


Costing Is Not Used
A. Obtain the entity’s computations of allocations of labor and overhead to specific items of
inventory or to the inventory as a whole when standard costing is not used. Assess the
reasonableness of management’s allocation methods and assumptions — see Possible
Procedures 5 and 6.
B. For allocations of labor and overhead to specific items of inventory or to the inventory as a
whole:
(1) Trace labor rates and production hours to supporting documents (e.g., union
contracts, production records).
(2) Determine that the bases for allocating various types of overhead expenses are
reasonable. Trace key amounts shown in the computations to general ledger balances
and other supporting documents.
(3) Recalculate the extensions and additions of labor and overhead allocations.
C. Determine if the entity’s allocation of fixed production overheads were based on the
normal capacity of the production facilities by performing the following:
(1) Inquire as to the entity’s policy for determining when the production level of
inventory is considered normal, abnormally high, abnormally low, or if a plant is
considered an idle plant.
(2) For those periods in which production was determined to be abnormally high,
abnormally low, or if a plant was considered idle, obtain documentation supporting
that assessment.

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a. Determine that for instances in which the production level was considered
abnormally high, that the amount of fixed overhead allocated to each unit of
production was decreased (i.e., capitalized fixed overhead costs were decreased,
so that the total amount capitalized did not exceed the amount of total overhead
costs incurred in the period).
b. Determine that for instances in which the production level was considered
abnormally low or the plant was considered idle that the amount of fixed
overhead allocated to each unit of production was not increased (i.e., not
adjusted upward, thereby incorrectly capitalizing overhead costs that should be
expensed as current period costs).
(3) Verify that unallocated overheads were recognized as expense in the period in which
the costs were incurred by agreeing the amounts to the appropriate general ledger
account.

Possible Procedure 5 — Testing Entity’s Methodology for Establishing Reserves


for Slow Moving, Excess and Obsolete Inventory
A. Obtain a schedule of the reserves for slow moving, excess and obsolete inventory.
(1) Test the summarization of the schedule.
(2) Trace the ending balance to the general ledger.
(3) Verify that any defective, obsolete, or unsaleable inventories noted during the
physical observation have been appropriately considered in the determination of the
inventory reserves or were separately written down.
B. Understand, document, and evaluate the reasonableness of the methods and assumptions
management used to develop the estimate.
C. If management’s methods and assumptions were reasonable, test the accuracy and
completeness of the data used by management by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures may include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
D. Indentify and obtain audit evidence to support the key assumptions underlying the estimate.
E. In instances when the audit evidence is inconsistent among differing sources, perform
additional audit procedures to resolve the inconsistency.

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F. Using the appropriate data, assumptions, and methodology, recompute the estimates.
G. If management's methods and assumptions were NOT reasonable, see Possible Procedure
6.

Possible Procedure 6 — Developing Independent Expectation of Market


Valuation Reserves or Allocations of Overhead
A. Develop a point estimate or range.
B. When developing a point estimate or range, obtain audit evidence to support that the data
used to make our point estimate or range is independent and reliable and, if we are using
information produced by the entity, that it is accurate and complete.
C. When using information that is produced by the entity, obtain audit evidence about the
accuracy and completeness of the data by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures ordinarily include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
D. In instances when the audit evidence to be used in forming our expectations is inconsistent
among differing sources, perform additional audit procedures to resolve the inconsistency.
E. Compare the recorded amount(s) to our point estimate or range and evaluate any
differences. When a point estimate has been developed, the difference between our point
estimate and the recorded estimate constitutes a misstatement. When a range provides
sufficient appropriate audit evidence and the recorded estimate lies outside the range, the
misstatement is no less than the difference between the recorded amount and the nearest
point in the range.

Possible Procedure 7 — Performing a Retrospective Review of Significant


Accounting Estimates
A. Perform a retrospective review of significant accounting estimates related to reserves of the
prior year and consider the results of this retrospective review in evaluating the current-
year estimates. If we identify a possible bias on the part of management in making
accounting estimates, we should evaluate whether circumstances producing such a bias
represent a risk of a material misstatement due to fraud.

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Possible Procedure 8 — Testing Valuation of Transactions Denominated in


Foreign Currency
A. Inquire about and consider other available evidence, if any, to identify account balances or
transactions denominated in foreign currencies. Trace currency-translation adjustments to
the general ledger. Identify applicable exchange rates and agree them to an independent
source. Test the translations calculations. Determine the impact of foreign-currency
hedging contracts or forward cover, if any, on the recorded balance of foreign-currency
related balances or transactions.

ACCOUNT BALANCE ASSERTION —RIGHTS AND OBLIGATIONS OF


INVENTORY

Possible Procedure 1 — Perform Procedures for Inventories Owned by the


Entity but Held by Others
A. If it is not practicable to observe and count inventories owned by the entity but held by
others:
(1) Prepare, or have the entity prepare, the confirmation requests for inventories owned
by the entity but held by others as of the balance sheet date.
(2) Prepare second requests for nonreplies.
(3) Compare replies to requests. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF INVENTORY

Possible Procedure 1 — Observe and Test-Count Inventories


A. On the date of our physical inventory observation, perform test counts of inventories by
making an audit sample of inventory items from the floor, and trace quantities to the
entity’s count records.

Possible Procedure 2 — Perform Procedures for Inventories Owned by the


Entity but Held by Others
A. For confirmations sent to third-parties related to Possible Procedure 3 for testing of the
Existence assertion, rather than requesting a confirmation of a specific inventory item
included in the entity’s inventory records, request the consignee or third-party warehouse
provide a complete list of inventory held at the third-party location but owned by the entity.

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PROPERTY, PLANT, AND EQUIPMENT

ACCOUNT BALANCE ASSERTION — EXISTENCE OF PROPERTY, PLANT, AND


EQUIPMENT

Possible Procedure 1 — Test Property, Plant, and Equipment Additions


A. Obtain a schedule of property, plant, and equipment showing beginning balance, additions,
disposals, and ending balance.
B. Test the summarization of the schedule and agree balances to the general ledger.
C. Make an audit sample from current-period purchases/acquisitions of property, plant, and
equipment. For each selection, perform the following:
(1) Physically inspect the asset, if possible, or determine by other means that the asset is
owned and still in use by the entity.
(2) Review supporting documentation to verify the selection is properly approved and
includes no amounts of an expense nature.
(3) If the selected asset replaced an asset, verify that the asset replaced was properly
recorded as a disposal. For those assets selected that were disposed of during the
current period, or for those selections that replaced another asset during the current
period:
a. Examine the documents authorizing the disposal. Verify the disposed asset is
excluded from the listing of property, plant, and equipment at the end of the
period.

Possible Procedure 2 — Analytically Test Property, Plant, and Equipment


Additions
A. Perform substantive analytical procedures to test property additions (including construction
in progress and/or construction transferred into service during the period).
(1) Consider using ACL (or another method if more efficient) to develop expectations of
property additions (including construction in progress and/or construction transferred
into service during the period) using information such as prior-year property
additions, monthly amounts of property purchases and sales, and forecasted capital
expenditures.
(2) Use ACL (or another method if more efficient) to disaggregate both the data used to
build the expectations and the various recorded property balances at a level of detail
sufficient to enable us to obtain the desired level of assurance based on a comparison
of amounts.
(3) Analyze changes in property categories during the period and consider their
reasonableness in view of historic and current information, such as increased
productivity, business plans, etc.
(4) Obtain the information necessary to audit the cash flow statement. Information may

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include details of cash paid for property purchases. If the indirect method is used,
obtain schedules supporting depreciation expense and any property purchases that are
accrued for in accounts payable.
(5) Determine the threshold.
(6) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

Possible Procedure 3 — Perform Test of Details on Property, Plant, and


Equipment for Unrecorded Disposals
A. Make an audit sample from property, plant, and equipment recorded at the beginning of the
period and from current period purchases/acquisitions of property, plant, and equipment.
For each selection, perform the following:
(1) Physically inspect the asset, if possible, and contact the process owner or department
to corroborate that the asset is still in use by the entity.
(2) If the asset is still in use by the entity, trace the selection to the listing of property,
plant, and equipment at the end of the period.
(3) If the asset was no longer in use by the entity, verify that the selection was properly
recorded as a disposal during the current period and excluded from the listing of
property, plant, and equipment at the end of the period.

Possible Procedure 4 — Perform Substantive Analytical Procedures to Test


Property, Plant, and Equipment for Unrecorded Disposals
A. Perform substantive analytical procedures to test property disposals.
(1) Consider using ACL (or another method if more efficient) to develop expectations of
property disposals and the gain or loss on disposals using information such as: prior
year property disposals; monthly amounts of property sales, useful lives, information
in prior year fixed asset register; and forecasted disposals.
(2) Use ACL (or another method if more efficient) to disaggregate both the data used to
build the expectations and the various recorded property balances at a level of detail
sufficient to enable us to obtain the desired level of assurance based on a comparison
of amounts.
(3) Obtain the information necessary to audit the cash flow statement. Information may
include details of cash received for property sales.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount

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of the difference, not just for the part that exceeds the threshold.

Possible Procedure 5 — Test Property, Plant, and Equipment Leases


A. Make an audit sample from assets held under capital (finance) leases as of the beginning of
the period and from current-period additions of capital (finance) leases. For each selection,
perform the following:
(1) Physically inspect the asset, if possible, or determine that the asset exists and is in use
by the entity.
(2) For new or modified leases, verify that the lease contract meets the criteria to be
accounted for as a capital lease.
(3) For selections which relate to assets that were no longer leased as of the balance sheet
date, verify that the lease termination was authorized and properly recorded, and that
the asset is excluded from the listing of property, plant, and equipment at the end of
the period.

Possible Procedure 6 — Using Analytical Procedures and/or Tests of Details to


Update Existence Tests Performed at an Interim Date
A. Make inquiries of facilities and operations management regarding significant or unusual
acquisitions or disposals, changes in budgeted capital expenditures, etc.
B. Develop expectations of the year-end account balance by considering factors identified
during the interim test as well as changes in facts or circumstances during the intervening
period identified through inquires.
C. Determine threshold.
D. Compare the expectation to the recorded amount and identify any differences. For any
difference that is more than the threshold, obtain, quantify, and corroborate explanations for
the difference by performing further analysis or inquiry and examining supporting
documents. Explanations need to be sought for the full amount of the difference, not just
for the part that exceeds the threshold.
And/or
E. Perform test of details on account balance change in the intervening period (i.e., from the
interim test date to the balance sheet date) by examining activity within the account
balance.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF PROPERTY, PLANT,


AND EQUIPMENT

Possible Procedure 1 — Test Repairs and Maintenance Expenses


A. Make an audit sample from repair and maintenance expenses recorded during the current
period. For each selection, perform the following:
(1) Trace the expenditure to supporting documentation (e.g., vendor invoices, contract).

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(2) Verify the selection is of an expense nature and is properly not capitalized and
excluded from the listing of property, plant, and equipment as of the balance sheet
date.

Possible Procedure 2 — Test Leases of Property, Plant and Equipment


A. Obtain a schedule of operating leases under which the entity is the lessee, and test
reconciliation to the general ledger.
B. Make inquiries of management and search for any evidence of additional leases (e.g.,
during work performed on payables and operating expenses).
C. Make an audit sample of operating leases from the entity’s schedule and for each selection,
read the lease agreement, and determine that the lease meets the criteria to be accounted for
as an operating lease.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF


PROPERTY, PLANT AND EQUIPMENT

Possible Procedure 1 — Test Property, Plant and Equipment for Unrecorded


Disposals
A. Make an audit sample from property, plant, and equipment recorded at the beginning of the
period and from current period purchases/acquisitions of property, plant, and equipment.
For each selection, perform the following:
(1) Physically inspect the asset, if possible, and contact the process owner or department
to corroborate that the asset is still in use by the entity.
(2) If the asset was no longer in use by the entity, verify that the selection was properly
recorded as a disposal during the current period and excluded from the listing of
property, plant, and equipment at the end of the period.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


PROPERTY, PLANT, AND EQUIPMENT

Possible Procedure 1 — Test Property, Plant, and Equipment Additions


A. For each of the selections made for Possible Procedure 1 for the Existence assertion,
perform the following:
(1) Trace the recorded costs of the selected asset to supporting documents (e.g., capital
expenditure approvals and vendor invoices for purchases in the current year).
(2) Review supporting documentation to verify the selection is properly approved and
includes no amounts of an expense nature.
(3) Evaluate the useful life assigned to the asset for reasonableness in relation to its
estimated future use.

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Possible Procedure 2 — Test Property, Plant, and Equipment Disposals


A. For each of the selections made for Possible Procedure 2 for the Existence assertion,
perform the following:
(1) Evaluate the remaining useful life of the asset for reasonableness in relation to its
condition and estimated future use.

Possible Procedure 3 — Perform Test of Details on Depreciation Expense


A. Make an audit sample from property, plant, and equipment recorded at the beginning of the
period and from current period purchase/acquisitions of property, plant, and equipment. For
each selection, perform the following:
(1) Recompute the current period depreciation expense amount and reconcile the
beginning accumulated depreciation amount to the ending amount.
B. Inquire into other significant entries recorded in the depreciation expense account.
Investigate these entries and trace them to supporting documentation.
C. Verify events have not occurred that might lead to a reduction in the period over which an
asset is being written off, or, in the extreme, lead to a total write-off of an asset (e.g.,
changes in production rendering some assets obsolete).

Possible Procedure 4 — Perform Substantive Analytical Procedures to Test


Depreciation Expense
A. Develop an expectation of depreciation expense for property, plant and equipment for the
current period using appropriate data such as the following:
(1) Property balances during the year and in prior years, depreciation expensed in prior
years, stated depreciation lives, or depreciation rates.
B. Disaggregate both the data used to build the expectations and the various depreciation
expense balances at a level of detail sufficient to enable us to obtain material
misstatements.
C. Determine that the data used to develop our expectation is independent and reliable and, if
we are using information produced by the entity, that it is accurate and complete by
considering the following:
(1) If the data is not independent, separately audit the data.
(2) In assessing the reliability of the data gathered, consider the source of the data and the
conditions under which it was gathered.
(3) For information that we are using that is produced by the entity, obtain audit evidence
about the accuracy and completeness of the data by either of the following means:
a. Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of operating effectiveness of
general computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
b. Perform audit procedures directly on the information being relied upon. These

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procedures may include either of the following:


i. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information.
ii. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s
underlying data or third-party source documents into the information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded balance and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just that part that exceeds the threshold.

Possible Procedure 5 — Test Future Cash Flows for Recoverability of Property,


Plant, and Equipment — Step 1 Impairment Analysis
A. Inquire of management to determine whether factors were identified in the current period
that may indicate the carrying amount of a long-lived asset (or an asset group) that the
entity expects to hold and use may not be recoverable.
(1) Verify that management has appropriately considered the following factors, events, or
changes in circumstances:
a. A significant decrease in the market price of a long-lived asset (asset group).
b. A significant adverse change in the extent or manner in which a long-lived asset
(asset group) is being used or in its physical condition.
c. A significant adverse change in legal factors or in the business climate that
could affect the value of a long-lived asset (asset group), including an adverse
action or assessment by a regulator.
d. An accumulation of costs significantly in excess of the amount originally
expected for the acquisition or construction of a long-lived asset (asset group).
e. A current-period operating or cash flow loss combined with a history of
operating or cash flow losses or a projection or forecast that demonstrates
continuing losses associated with the use of a long-lived asset (asset group).
f. A current expectation that, more likely than not, a long-lived asset (asset group)
will be sold or otherwise disposed of significantly before the end of its
previously estimated useful life.
B. For those long-lived assets (or asset groups) for which impairment indicators are present,
test management’s methodology and assumptions used in estimating future cash flows used
to test a long-lived asset (asset group) for recoverability.
(1) Verify that the entity’s estimates of future cash flows (undiscounted and without
interest charges) used to test the recoverability of a long-lived asset (asset group)
include only the future cash flows (i.e., cash inflows less associated cash outflows)

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that are directly associated with and that are expected to arise as a direct result of the
use and eventual disposal of the asset (asset group).
(2) Verify that estimated expected future cash flows are based on reasonable and
supportable assumptions considering, among other factors, the assumptions used by
the entity in developing other information for comparable periods, such as internal
budgets and projections.
(3) Verify that alternative courses of action for recovering the carrying amount of the
long-lived asset (asset group) were considered and included by the entity in
determining the final cash flow analysis.
(4) Verify that the entity considered the likelihood of possible outcomes if a range was
used to estimate the amount of possible future cash flows (undiscounted and without
interest charges) associated with the likely course of action.
(5) Verify the remaining useful life of the asset group was used in estimating future cash
flows to test the recoverability of a long-lived asset (asset group). Determine that the
remaining useful life of an asset group is based on the remaining useful life of the
primary asset of the group. The primary asset is the principal long-lived tangible asset
being depreciated, or intangible asset being amortized, that is the most significant
component asset from which the asset group derives its cash-flow-generating
capacity. The primary asset of an asset group, therefore, cannot be land or an
intangible asset not being amortized. Factors that the entity should have considered in
determining whether a long-lived asset is the primary asset of an asset group include
the following:
a. Whether other assets of the group would have been acquired by the entity
without the asset
b. The level of the investment that would be required to replace the asset, and
c. The remaining useful life of the asset relative to other assets of the group.
i. If the primary asset is not the asset of the group with the longest remaining
useful life, verify that the entity’s estimates of future cash flows for the
group assume the sale of the group at the end of the remaining useful life
of the primary asset.
ii. Verify that the entity’s estimate of future cash flows used to test the
recoverability of the long-lived asset (asset group) that is in use, including
long-lived assets (asset groups) for which development is substantially
complete, is based on the existing service potential of the asset (asset
group) at the date it was tested for recoverability by the entity.
iii. Verify that the entity’s estimates of future cash flows include cash flows
(undiscounted and without interest charges) associated with future
expenditures necessary to maintain the existing service potential of a long-
lived asset (asset group), including those that replace the service potential
of component parts of a long-lived asset (e.g., the roof of a building) and
component assets other than the primary asset of an asset group.
iv. Verify that the entity’s estimates of future cash flows (undiscounted and

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without interest charges) used to test the recoverability of the long-lived


assets (asset groups) which are in use and for which development is
substantially complete, exclude cash flows associated with future capital
expenditures that would increase the service potential of the long-lived
assets (asset groups).
v. Verify, for long-lived assets (asset groups) under development that are not
substantially complete, that the entity’s estimates of future cash flows used
to test the recoverability of the long-lived asset (asset group) include cash
flows associated with all future expenditures necessary to develop the
long-lived asset (asset group), including interest payments that will be
capitalized as part of the cost of the asset (asset group).
vi. Verify, for long-lived assets that are under development and are part of an
asset group that is in use, that the entity’s estimates of future cash flows
used to test the recoverability of that group include the cash flows
associated with future expenditures necessary to maintain the existing
service potential of the group, as well as the cash flows associated with all
future expenditures necessary to substantially complete the asset that is
under development.
C. Compare the results of the future cash flow analysis with the carrying value of the long-
lived assets (assets group). Refer to Possible Procedure 4 if the carrying value of the long-
lived asset (asset group) is less than the entity’s estimated future cash flows of the long-
lived asset (asset group).

Possible Procedure 6 — Test Fair Value of Property, Plant, and Equipment —


Step 2 Impairment Analysis
A. Obtain and read the entity’s fair value analysis, including schedules and narratives, for
those long-lived assets (or asset groups) in which the carrying value of the long-lived asset
(or asset group) is less than the entity’s estimated future cash flows of the long-lived asset
(asset group).
B. Obtain the entity’s documentation that identifies the unit of account. Evaluate whether the
unit of account has been properly aggregated or disaggregated.
C. Obtain and evaluate the entity’s documentation and conclusion supporting the hypothetical
transaction to sell the asset or transfer the liability. Management’s documentation would
ordinarily include the following items (Note: If management’s documentation does not
include these items, the audit engagement team needs to obtain that information either by
(1) requesting management to document it and provide it, or (2) having discussions with
management and documenting such discussions):
(1) Identification of the exit market to sell the asset or transfer the liability (principal or
most advantageous market).
(2) Identification of the characteristics of market participants in the identified exit
market, including which characteristics were decided to be used and those decided
against.

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(3) Management’s conclusion on the highest and best use of the asset group and the
resulting valuation premise selected (“in-use” or “in-exchange”).
D. Test the valuation technique, model, and inputs including management’s significant
assumptions and the underlying data by performing the following:
(1) Evaluate whether the valuation technique or techniques (i.e., valuation methodology)
is/are appropriate in the circumstances and whether the technique or techniques used
for determining fair value is/are applied consistently with the preceding periods
(given possible changes in the environment or circumstances affecting the entity or
changes in accounting principles).
(2) Evaluate whether a change in the valuation technique or its application (e.g., a change
in its weight when multiple valuation techniques are used) is appropriate if the change
results in a measurement that is equally or more representative of fair value in the
circumstances (e.g., new markets develop, new information becomes available,
information previously used is no longer available, or valuation methods improve).
(3) Assess the reasonableness of the valuation assumptions (or “inputs”) used in the fair
value analysis and whether the valuation assumptions are consistent with what market
participants would use in pricing the item.
(4) Assess the reasonableness of the business and accounting assumptions used in the fair
value analysis and whether the business and accounting assumptions are consistent
with what market participants would use in pricing the item.
(5) Evaluate whether the fair value has not been adjusted for transactions costs.
(6) Evaluate whether the fair value has been adjusted for transportation costs when
location is an attribute of the asset or liability (as might be the case for a commodity).
(7) Evaluate whether the fair value model being used is appropriate considering the
entity’s circumstances and valuation premise (in-use or in-exchange) identified (e.g.,
do the assumptions, methods, and circumstances all form an appropriate model).
(8) Test the mathematical accuracy of the portions of the fair value model related to the
valuation assumptions by recomputing the amounts, or by other appropriate means.
(9) Test the mathematical accuracy of the portions of the fair value model related to the
business and accounting assumptions by recomputing the amounts, or by other
appropriate means.
(10) Test the mathematical accuracy of the overall model by footing, cross-footing, and
recalculating, as appropriate, to the extent not already completed.
(11) Test the underlying data used to develop the fair value measurement to determine that
the information used in the analysis is accurate and complete.
E. Evaluate whether a sensitivity analysis needs to be prepared, based on results of audit
procedures performed above, for comparison to the entity’s fair value estimate.
F. If a sensitivity analysis is prepared, compare the entity’s estimate to the amount (or range
of reasonable amounts) resulting from the sensitivity analysis. Any difference between the
entity’s estimate and the closest reasonable estimate is a misstatement.

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G. If an Internal Fair Value Specialist is involved, obtain, read, and discuss the findings
memorandum prepared by the Internal Fair Value Specialist, resolve any issues identified,
obtain and review all supporting working papers, and retain the Findings Memo and
working papers in the audit file.
H. Test the level of the fair value hierarchy within which management identified the asset or
liability falls in its entirety based on the lowest level input/assumption that is significant to
the fair value estimate in its entirety.
I. Compare the carrying amount of the long-lived asset (asset group) to its fair value. If the
carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair
value, perform the following procedures:
(1) Recompute and trace the impairment loss to the applicable general ledger account.
The impairment loss is equal to the amount by which the carrying amount of the long-
lived asset (asset group) exceeds its fair value as recorded in the applicable general
ledger account.
(2) Determine that the reduced carrying amount of the asset is accounted for as its new
cost basis and that the new cost basis is depreciated over the asset’s remaining useful
life.
(3) Verify that previously recognized impairment losses are not restored.
(4) If an impairment loss is recognized for an asset group, determine that the entity has
allocated the loss to the long-lived assets on a pro rata basis using the relative
carrying amounts of those assets (unless the fair value of an individual asset is
determinable without undue costs and effort, in which case the allocation of the
impairment should not reduce the carrying amount of the asset below its fair value).

Possible Procedure 7 — Test Property, Plant, and Equipment Classified as Held-


for-Sale
A. Obtain and evaluate the entity’s documentation supporting the grouping of a long-lived
asset as held-for-sale (or group of assets hereinafter called a disposal group, defined as
assets to be disposed of together as a group in a single transaction and liabilities directly
associated with those assets that will be transferred in the transaction).
B. Test that the long-lived assets (disposal groups) meet all recognition criteria during the
period the long-lived assets (disposal groups) have been classified as held-for-sale.
C. Obtain and evaluate the entity’s documentation supporting the measurement of long-lived
assets held-for-sale and perform the following:
(1) Verify that the entity has measured the long-lived asset (disposal group) at the lower
of its carrying amount or fair value less cost to sell.
(2) Test the entity’s estimate of fair value of the long-lived asset (disposal group).
Consider obtaining the assistance of an Internal Fair Value Specialist.
(3) Test selling costs to determine that incremental direct costs to transact the sale of the
asset, such as broker commissions, and legal and title transfer fees that must be
incurred before legal title can be transferred, have been included and other costs, such

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as costs of protecting or maintaining the asset, have been excluded (unless required
by a contractual agreement to sell the asset).
(4) If the fair value of the asset is measured by discounting expected future cash flows
and if the sale is expected to occur beyond one year as permitted in limited situations,
verify that the cost to sell has been discounted by the entity.
(5) Recalculate the gain or loss as a result of recording the long-lived asset (disposal
group) at the lower of its carrying amount or fair value less cost to sell, and agree the
gain or loss to the general ledger.
(6) Verify that no depreciation or amortization was recorded by the entity while the asset
(disposal group) was classified as held-for-sale.

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GOODWILL AND OTHER INTANGIBLE ASSETS

ACCOUNT BALANCE ASSERTION — EXISTENCE OF GOODWILL AND OTHER


INTANGIBLE ASSETS

Possible Procedure 1 — Perform Test of Details on Intangible Assets (Other


Than Goodwill)

A. Obtain schedules of patents, copyrights, and other intangible assets, showing beginning and
ending balances and acquisitions and disposals during the current period, as well as
amounts written-off during the period. The schedules may also show a description of each
asset, the date of acquisition, the useful life (if applicable), and the sales proceeds and
profit or loss on a disposal (if applicable).

B. Test the summarization of the schedule.

C. Trace year-end asset totals to the appropriate balance sheet account in the general ledger
and charges for the year (i.e., amortization and/or impairment charges) to the appropriate
income statement account in the general ledger.

D. Make an audit sample of intangible asset additions (acquired or internally developed)


recorded in the current year. For each selection perform the following:
(1) Trace additions to the appropriate authorizations or board minutes, if applicable.
(2) Trace additions to independent supporting evidence, if applicable.

Possible Procedure 2 — Perform Test of Details on Goodwill

A. Obtain schedules of goodwill, showing beginning and ending goodwill balances and
acquisitions that resulted in goodwill and disposals during the current period, as well as
amounts written off during the period.

B. Test the summarization of the schedule.

C. Trace year-end asset totals to the appropriate balance sheet account in the general ledger
and charges for the year (i.e., amortization and/or impairment charges) to the appropriate
income statement account in the general ledger.

D. For testing of goodwill acquired in a business combination in the current year, perform
procedures outlined in the “Business Combination” Substantive Procedures Guide.

Possible Procedure 3 — Using Test of Details to Update Existence Tests


Performed at an Interim Date

A. Perform test of details on account balance changes in the intervening period (i.e., from the
interim test date to the balance sheet date) by examining activity within the account

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balance.

B. Perform additions testing on activity that occurred in the intervening period as described in
Possible Procedure 1 and for additions to goodwill, perform procedures outlined in the
“Business Combination” Substantive Procedures Guide.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


GOODWILL AND OTHER INTANGIBLE ASSETS

Possible Procedure 1 —Test Valuation of Goodwill — Step 1 of Goodwill


Impairment Test

A. Determine that goodwill is not being amortized.

B. Determine that goodwill of a reporting unit is tested for impairment (at least) annually, at
the same time of the year (different reporting units may be tested for impairment at
different times), and between annual tests if an event occurred or circumstance changed
that would more likely than not reduce the fair value of a reporting unit below its carrying
amount. Examples of such events include:
(1) A significant adverse change in legal factors or in the business climate
(2) An adverse action or assessment by a regulator
(3) Unanticipated competition
(4) A loss of key personnel
(5) A more-likely-than-not expectation that a reporting unit or a significant portion of a
reporting unit will be sold or otherwise disposed of
(6) The testing for recoverability of a significant asset group within a reporting unit
(7) Recognition of a goodwill impairment loss in the financial statements of a subsidiary
that is a component of a reporting unit
(8) Allocation of a portion of goodwill to a business to be disposed of
(9) Certain conditions or events causing a decline in the quoted market price of the
entity’s equity securities.

C. Obtain the entity’s goodwill impairment analysis for the current year and perform the
following procedures:
(1) Determine if the following considerations were included in the entity’s determination
of its reporting units:
a. A reporting unit is an operating segment or one level below an operating
segment (referred to as a component). For each operating segment, determine
that the entity has identified the components of the operating segment.
Determine that such components of an operating segment have been designated
by the entity as a reporting unit only if the following criteria have been met:

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i. The component constitutes a business for which discrete financial


information is available.
ii. Segment management regularly reviews the operating results of that
component.
iii. Two or more components of the operating segment have dissimilar
economic characteristics.
(2) Determine that the entity properly aggregated components that have similar economic
characteristics. In determining whether components should be combined into one
reporting unit based on their economic similarities, determine that the entity
considered:
a. The manner in which the entity operates its business and the nature of those
operations.
b. Whether goodwill is recoverable from the separate operations of each
component business or from two or more component businesses working
together.
c. The extent to which the component businesses share assets and other resources.
d. Whether the components support and benefit from common research and
development projects.

D. Agree the historical totals included in the impairment analysis to prior-year working
papers.

E. Assess whether the valuation technique used by management and the underlying
assumptions are reasonable.

F. If we conclude that management’s valuation technique and assumptions used to develop the
estimate are reasonable, test the assumption and supporting data (e.g., cash flow data,
including terminal cash flows, growth rates and future revenue projections, discount rates,
anticipated cost savings, and capital expenditures) by performing the following: [Note: For
information that we are using that is produced by the entity, obtain audit evidence about the
accuracy and completeness.]
(1) Compare historical percentages for key measures to projection assumptions and
consider current-year matters which might affect those historical relationships.
(2) Perform a retrospective review of the prior-year projected assumptions versus the
current actual for each reporting unit.
(3) Understand the impact of changes in assumptions including the discount rate and
expected growth rate.
(4) Consider obtaining the assistance of an Internal Fair Value Specialist to the extent
necessary to evaluate the reasonableness of the assumptions.
(5) The following are some items that may be considered in evaluating the assumptions:
a. The general economic environment and the entity’s economic circumstances,

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considering external information when available.


b. The plans of the entity.
c. Experience of, or previous conditions experienced by, the entity to the extent
currently applicable.
d. Other matters relating to the financial statements (e.g., assumptions used by
management in accounting estimates for other financial statement accounts).
e. The risk associated with cash flows, including the potential variability of the
cash flows and the related effect on the discounted-rate, financial results and
operating history of the entity.
f. Whether assumptions are based on plans that are within the entity’s capacity and
in accordance with management’s intent.

G. Evaluate whether the data on which management’s assumptions are based, are accurate,
complete, and relevant.

H. If applicable, obtain the entity’s reconciliation of its market capitalization to the aggregate
sum of the fair value of its reporting units.

I. Compare the fair value of the reporting unit to the carrying amount (including goodwill)
and if the fair value of the reporting unit exceeds its carrying amount (including goodwill),
the reporting unit is not considered impaired. If the fair value of the reporting unit is below
the carrying amount (including goodwill), perform Step 2 of the impairment test — see
Possible Procedure 2.

J. Document the results of the entity’s impairment test.

K. When goodwill and another asset (or asset group) are tested for impairment at the same
time, and the asset group is impaired, determine that the impairment loss has been
recognized prior to goodwill being tested for impairment.

Possible Procedure 2 — Test Valuation of Goodwill — Step 2 of Goodwill


Impairment Test

A. When the fair value of the reporting unit is less than its carrying amount and management
has performed Step 2 of the goodwill impairment test, perform the following procedures:
(1) Recalculate the implied fair value of reporting unit goodwill.
(2) Determine that management allocated the fair value of the reporting unit to all the
assets and liabilities (including any recognized and unrecognized intangible assets) as
if the reporting unit had been acquired in a business combination. The excess of the
fair value of a reporting unit over the amounts assigned to its assets and liabilities is
the implied fair value of reporting unit goodwill.
(3) Recalculate the goodwill impairment loss. The goodwill impairment loss is equal to
the amount by which the carrying amount of reporting unit goodwill exceeds the
implied fair value of that goodwill.

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(4) Verify that no assets or liabilities were written up or written down as a result of
calculating the implied fair value of goodwill.
(5) Verify that no previously unrecognized intangible assets were recognized as a result
of calculating the implied fair value of goodwill.
(6) Verify that the impairment loss recognized does not exceed the carrying amount of
reporting unit goodwill.
(7) When subsidiary goodwill has been tested for impairment at the subsidiary level,
using the subsidiary’s reporting units, determine that the following procedures have
been performed:
a. If a goodwill impairment loss has been recognized at the subsidiary level, the
goodwill of the reporting unit(s) (at the higher consolidated level) in which the
subsidiary’s reporting unit with impaired goodwill resides has been tested for
impairment, if the event that gave rise to the loss at the subsidiary level would
more likely than not reduce the fair value of the reporting unit (at the higher
consolidated level) below its carrying amount.
b. As a result of applying Step (7)a (i.e., the goodwill of the higher-level reporting
unit is impaired), a goodwill impairment loss pertaining to goodwill at the
higher-level reporting unit has been recognized at the consolidated level,
perform the following:
i. Trace the amount of the impairment loss (if any) to the appropriate income
statement account in the general ledger.
ii. Document the results of the entity’s impairment test.

Possible Procedure 3 — Test Valuation of Intangible Assets (Other Than


Goodwill) with Indefinite Useful Lives

A. Obtain a listing of indefinite lived intangible assets and determine the reasonableness of the
indefinite useful life classification given current events and circumstances.

B. Verify whether, during the period (1) those assets considered to have indefinite useful lives
are not being amortized, but rather tested for impairment annually, or (2) if events or a
change in circumstance indicate that impairment may exist.

C. Obtain the entity’s intangible assets impairment analysis for the current year.

D. Test management’s fair value measurement as indicated below:


(1) Obtain the entity’s documentation that identifies the unit of account. Evaluate
whether the unit of account has been properly aggregated or disaggregated in
accordance with the applicable accounting pronouncements.
(2) Obtain the entity’s documentation supporting the hypothetical transaction to sell the
asset or transfer the liability. Management’s documentation would ordinarily include
the following items. (Note: If management’s documentation does not include these
items, the audit engagement team needs to obtain that information either by (1)

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requesting management to document and provide it, or (2) having discussions with
management and documenting such discussions):
a. Identification of the exit market to sell the asset or transfer the liability
(principal or most advantageous market).
b. Identification of the characteristics of market participants in the identified exit
market, including which characteristics were used and which were decided
against.
c. For assets, management’s conclusion on the highest and best use of the asset
group and the resulting valuation premise selected (“in-use” or “in-exchange”).
(3) Obtain the entity’s documentation supporting the level in the fair value hierarchy
within which the fair value measurement, in its entirety, falls. This is determined
based on the lowest level input that is significant to the fair value measurement in its
entirety.
(4) Evaluate management’s conclusion on the following items:
a. Identified exit market as either the principal or most advantageous market based
on volume and level of activity from the reporting entity’s perspective.
b. If there is a principal market, whether the fair value measurement represents the
price in the market (whether that price is directly observable or otherwise
determined using a valuation technique) even if the price in a different market is
potentially more advantageous at the measurement date.
c. Characteristics of market participants and whether the entity identified
characteristics that distinguish market participants generally, considering factors
specific to (a) the asset or liability, (b) the principal (or most advantageous)
market for the asset or liability, and (c) market participants with whom the
reporting entity would transact in that market in developing the assumptions.
d. For assets, the highest and best use and resulting valuation premise (in-use or
in-exchange).
e. Whether the fair value of an asset has been measured using an in-use or an in-
exchange valuation premise, using market participant assumptions (even if the
intended use of the asset by the reporting entity is different), as appropriate.
f. If the highest and best use of the asset is “in-use,” whether the fair value of the
group of assets has been determined based on the price that would be received
in a current transaction to sell the asset assuming the asset would be used with
other assets as a group and that those assets would be available to market
participants.
g. If the highest and best use of the group of assets is “in-exchange,” whether the
fair value of the asset has been based on the price that would be received in the
current transaction to sell the asset on a standalone basis.
(5) Make inquiries of entity personnel with direct knowledge of the asset or liability.
(6) Inquire about similar transactions the entity entered into previously and obtain

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documentation if applicable.
(7) Consider the industry in which the entity operates and assess whether contradictory
information is present that would question or invalidate management’s conclusions.
(8) Obtain other internal or external analyses and supporting data when applicable (e.g.,
transaction costs if they were considered in determining the most advantageous
market).

E. Test the valuation technique, model and inputs, including management’s significant
assumptions and the underlying data by performing the following:
(1) Evaluate whether the valuation technique or techniques (i.e., valuation methodology)
is/are appropriate in the circumstances and whether the technique or techniques used
for determining fair value is/are applied consistently with the preceding periods.
Consider the following:
a. Whether the valuation technique (i.e., method) of measurement maximizes the
use of observable inputs and minimizes the use of unobservable inputs.
b. Whether a single valuation technique or multiple valuation techniques is/are
appropriate in the circumstances and for which sufficient data is available.
c. In instances where management has determined that different valuation
techniques result in a range of significantly different fair value measurements,
how the entity investigated the reasons for these differences in establishing its
fair value measurements.
d. In circumstances where multiple valuation techniques were employed, whether
the results were evaluated and weighted appropriately to identify a single
estimate within a reasonable range that is most representative of the fair value.
e. Whether the valuation technique is appropriate in relation to the business,
industry, and environment in which the entity operates.
(2) Evaluate whether a change in the valuation technique or its application (e.g., a change
in its weighting when multiple valuation techniques are used) is appropriate if the
change results in a measurement that is equally or more representative of fair value in
the circumstances (e.g., new markets develop, new information becomes available,
information previously used is no longer available or valuation methods improve).
a. If the item was tested in the prior year, compare to the valuation technique or
techniques used in the prior year for consistency.
b. Determine that any revisions resulting from a change in a valuation technique or
its application (e.g., a change in its weighing when multiple valuation
techniques are used) are accounted for as a change in accounting estimate.
c. Assess reasonableness of the valuation assumptions (or “inputs”) used in the
fair value analysis and whether the valuation assumptions are consistent with
what market participants would use in pricing the item.
(3) Evaluate whether management used relevant information that was reasonably
available at that time.

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(4) Evaluate whether management used observable inputs first (Level 1, then Level 2,
then Level 3) to the extent possible in determining the valuation assumptions
following the fair value hierarchy.
(5) Evaluate whether an adjustment for risk is necessary to any of the valuation
assumptions used by management. An adjustment for risk would be appropriate if the
identified market participants would include one in pricing the asset or liability.
(6) Whether the entity has reflected the nonperformance risk in measuring the fair value
of a liability, thereby considering the effect of changes in its credit risk (credit
standing) on the fair value of a liability as well as credit enhancements related to the
liability, if any.
(7) Agree information used in developing the key valuation assumptions to appropriate
supporting documentation.
(8) Consider whether the valuation assumptions, taken individually and as a whole, are
realistic and consistent with the following:
a. The general economic environment, the economic environment of the entity’s
specific industry, and the entity’s economic circumstances.
b. Existing market information.
c. The entity’s plans and experience, to the extent currently applicable, including
management’s expectations for the outcome of specific objectives and strategies
adjusted for any considerations market participants would make.
d. Valuation assumptions made in prior periods. Compare assumptions used in the
prior year to those used in the current year. Inquire as to material variances
between the periods.
e. Other matters relating to the financial statements (e.g., assumptions used by
management in other fair value measurements.)
f. The risk associated with cash flows, including the potential variability in the
amount and timing of the cash flows and the related effect on the discount rate.
(9) Test the mathematical accuracy of the portions of the fair value model related to the
valuation, business, and accounting assumptions by recomputing the amounts, or by
other appropriate means.
(10) Test the underlying data used to develop the fair value measurement and disclosure to
determine that the information used in the analysis is accurate and complete. Such
tests might include:
a. Agreeing the data to appropriate supporting documentation.
b. Recomputing mathematical inputs.
c. Reviewing data for internal consistency.
(11) Consider whether a sensitivity analysis needs to be prepared, based on results of audit
procedures performed above, for comparison to the entity’s fair value estimate.
Ordinarily, a sensitivity analysis is prepared when we find:

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a. One or more assumption(s) (input(s)) to not be reasonable,


b. The valuation techniques are not appropriate or multiple techniques were not
used in circumstances where they are appropriate and for which sufficient data
is available, or
c. A mathematical or computational error is identified in the model.
(12) When a sensitivity analysis needs to be prepared, identify and use reasonable
assumptions, appropriate valuation techniques, and proper mathematics.
(13) When a sensitivity analysis is prepared, compare the entity’s estimate to the amount
(or range of reasonable amounts) resulting from the sensitivity analysis. Any
difference between the entity’s estimate and the closest reasonable estimate is a
misstatement.
(14) When an Internal Fair Value Specialist is involved, obtain, read, and discuss the
findings memorandum prepared by the Internal Fair Value Specialist, resolve any
issues identified, obtain and review all supporting working papers, and retain the
Findings Memo and working papers in the audit file.

Possible Procedure 4 — Test Useful Lives of Intangible Assets (Other Than


Goodwill) with Finite Useful Lives

A. Determine that intangible assets with finite useful lives are being amortized over their
useful lives (i.e., the period over which the asset is expected to contribute directly or
indirectly to the future cash flows of the entity).
(1) In developing assumptions about renewal or extension used to determine the useful
life of a recognized intangible asset, determine that the entity considered its own
historical experience in renewing or extending similar arrangements (regardless of
whether those arrangements have explicit renewal or extension provisions), adjusted
for the entity-specific factors.
(2) In the absence of its own historical experience, verify that the entity considered the
assumptions that market participants would use about renewal or extension
(consistent with the highest and best use of the asset by market participants), adjusted
for the entity-specific factors.
(3) If an entity used the income approach in determining the useful life of the intangible
asset for amortization purposes, determine that the entity considered the period of
expected cash flows used to measure the fair value of the intangible asset, adjusted as
appropriate for the entity-specific factors.
a. Determine that intangible assets with unknown finite useful lives are being
amortized over the best estimate of their useful lives.
b. Evaluate whether events or circumstances have occurred that do not support the
useful life used in determining amortization.
c. Make a selection of the intangible assets tested in Possible Procedure 1 and
perform tests of details for amortization expense.

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d. Recompute the amortization amount. The method of amortization should reflect


the pattern in which the economic benefits of the intangible asset are consumed
or otherwise expended. If that pattern cannot be reliably determined, a straight-
line amortization method should be used.
e. Determine that the amount of the intangible asset being amortized is the amount
initially assigned to the asset less any residual value.
f. Test summarization of the schedule and trace ending balances of accumulated
amortization to the general ledger.
g. Verify that the useful life of each intangible asset that is being amortized has
been evaluated at each reporting period to determine whether events and
circumstances warrant a revision to the remaining period of amortization.
h. When an intangible asset’s remaining useful life has changed, determine that the
remaining carrying amount is being amortized prospectively over the revised
remaining useful life.

Possible Procedure 5 — Test Intangible Assets (Other Than Goodwill) with


Finite Useful Lives for Impairment

A. Evaluate whether events or a change in circumstance exist that may indicate a potential
impairment.

B. When intangible assets subject to amortization have been reviewed for impairment as a
result of events or a change in circumstance that indicate impairment may exist, obtain the
entity’s intangible assets impairment test that management performed.

C. Verify that the intangible assets (asset group) are grouped with other assets and liabilities at
the lowest level for which identifiable cash flows are largely independent of the cash flows
of other assets and liabilities.

D. Obtain and evaluate the entity’s estimates of future cash flows used to test the
recoverability of the intangible asset (asset group).

E. Determine whether the factors that management considered and the assumptions that
management made to develop the estimate were appropriate in the circumstances.

F. If we conclude that management considered the appropriate factors and made reasonable
assumptions to develop the estimate, test the supporting data.

G. Compare the carrying amount of the intangible asset (asset group) to the sum of the
undiscounted cash flows expected to result from the use and eventual disposition of the
asset (asset group).

H. If the carrying amount of the intangible asset (asset group) exceeds the sum of the
undiscounted cash flows and is not recoverable, perform procedures such as those listed in
Possible Procedure 3, Step D for testing of fair value.

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Possible Procedure 6 — Test Valuation of Intangible Assets (Other Than


Goodwill) Acquired (Other Than in a Business Combination) or Internally
Developed

A. For intangible assets selected in Possible Procedure 1, Step D, for the testing of the
Existence assertion above, perform one of the following:
(1) For intangible assets acquired other than in a business combination, obtain the
purchase agreement, sales contract, or other supporting documenting and vouch
payment.
(2) For internally developed intangible assets, obtain schedules supporting the cost build-
up and test details for accuracy and completeness.

Possible Procedure 7 — Performing a Retrospective Review of Significant


Accounting Estimates

A. Perform a retrospective review of actual results against prior forecasts to assess the
accuracy of management’s forecasting process. If we identify a possible bias on the part of
management in making forecasts, we should evaluate whether circumstances producing
such a bias represent a risk of a material misstatement due to fraud.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF


GOODWILL AND OTHER INTANGIBLE ASSETS

Possible Procedure 1 — Test Intangible Assets and Goodwill for Rights and
Obligations

A. Obtain listing of all intangible assets and goodwill by reporting unit.

B. Based on knowledge obtained from audit work on other account balances, determine
whether a goodwill or intangible asset appears to be assigned to reporting units that were
disposed of in the current period.

C. Inquire of management and those knowledgeable of the reporting units if intangibles or


goodwill balances remain post disposition. Evaluate management’s response.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF GOODWILL AND


OTHER INTANGIBLE ASSETS

Possible Procedure 1 — Test Intangible Assets for Completeness

A. Obtain the detail of expenses recorded during the period related to internally developed
intangible assets.

B. Make an audit sample and obtain supporting documentation.

C. Evaluate whether such costs were appropriately expensed during the period versus

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capitalized.

Possible Procedure 2 — Test Goodwill for Completeness

A. For business combinations consummated in the current period for which no goodwill has
been recorded, evaluate whether that is consistent with our audit procedures performed as
outlined in the “Business Combination” Substantive Procedures Guide.

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ACCOUNTS PAYABLE

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF ACCOUNTS


PAYABLE

Possible Procedure 1 — Test Accounts Payable Balance — Perform Subsequent


Disbursements Testing
A. Calculate the entity’s payable cycle.
B. Make an audit sample from subsequent cash disbursements. For each selection, perform the
following:
(1) Trace the subsequent cash disbursement to supporting documentation (purchase order,
vendor invoice, receiving report).
(2) Verify, if the selection relates to the current audit period, that the selection is properly
recorded in accounts payable or other accrued account.
C. Make an audit sample of unpaid invoices. For each selection, perform the following:
(1) If the unpaid invoice represents a liability as of the balance sheet date, trace to proper
inclusion in accounts payable or other accrued account.
D. If the population that was used in Procedure B does not cover a full payable cycle, as noted
in Procedure A, consider whether sufficient audit evidence was obtained and consider the
use of alternative procedures or additional audit samples.

Possible Procedure 2 — Test Debits in Accounts Payable


A. Make an audit sample of recorded debits to accounts payable. For each selection, perform
the following:
(1) Trace the item to supporting documentation (e.g., receiving or shipping document,
debit note, original invoice).
(2) Verify that the item represents a proper reduction to the accounts payable balance.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


ACCOUNTS PAYABLE

Possible Procedure 1 — Testing Entity’s Methodology for Estimating Accrued


Trade Payables
A. Understand, document, and evaluate the reasonableness of the methods and assumptions
used by management to estimate accrued trade payables.
B. If management’s methods and assumptions were reasonable, test the accuracy and
completeness of the data used by management by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general

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computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures may include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
C. Identify and obtain audit evidence to support the key assumptions underlying the estimate.
D. In instances when the audit evidence is inconsistent among differing sources, perform
additional audit procedures to resolve the inconsistency.
E. Using the appropriate data, assumptions, and methodology, recompute the accrued trade
payable.

Possible Procedure 2 — Developing Independent Expectation of Accrued Trade


Payables
A. Develop a point estimate or range. Possible applicable factors when developing a point
estimate or range for accrued trade payables are (1) the level of the goods and services
received near period-end and (2) the historical lag between vendors delivering goods or
providing services and actual invoices being received.
B. When developing a point estimate or range, obtain audit evidence to support that the data
used to make our estimate is independent and reliable and, if we are using information
produced by the entity, that it is accurate and complete.
C. When using information that is produced by the entity, obtain audit evidence about the
accuracy and completeness of the data by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures ordinarily include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
D. In instances when the audit evidence to be used in forming our expectations is inconsistent
among differing sources, perform additional audit procedures to resolve the inconsistency.
E. Compare the recorded amount(s) to our point estimate or range and evaluate any

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differences. When a point estimate has been developed, the difference between our point
estimate and the recorded estimate constitutes a misstatement. When a range provides
sufficient appropriate audit evidence and the recorded estimates lies outside the range, the
misstatement is no less than the difference between the recorded amount and the nearest
point in the range.

Possible Procedure 3 — Performing Retrospective Review of Significant


Accounting Estimates Related to Accrued Trade Payables
A. Perform a retrospective review of significant accounting estimates related to accrued trade
payables of the prior year and consider the results of this retrospective review in evaluating
the current-year estimates. If we identify a possible bias on the part of management in
making accounting estimates, we should evaluate whether circumstances producing such a
bias represent a risk of a material misstatement due to fraud.

Possible Procedure 4 — Perform Test of Details on Accounts Payable


A. For selections made to test the Completeness assertion of accounts payable, agree
quantities and services received and prices per the invoices to purchases orders, master
vendor agreements, or other supporting documentation and test the mathematical accuracy
of the invoices.
B. Agree the totals per invoices to the general ledger.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF


ACCOUNTS PAYABLE

Possible Procedure 1 — Test Aged Trial Balance for Disputed Invoices


A. Inquire of members of management, including those independent of accounting department
(e.g., purchasing and receiving), as to the existence of significant disputed invoices. For
identified items, perform the following:
(1) Obtain audit evidence pertaining to the disputed invoice and document our
understanding of the disputed invoice/portion of invoice.
(2) Determine whether the disputed invoice should be included or excluded from the
aged trial balance at period-end.
(3) Trace disputed invoice to appropriate inclusion/exclusion in the period-end aged trial
balance.

ACCOUNT BALANCE ASSERTION — EXISTENCE OF ACCOUNTS PAYABLE

Possible Procedure 1 — Reconcile the Payables Trial Balance (Aging) to


General Ledger
A. Obtain the payables trial balance (aging) and the reconciliation of the payables trial balance
(aging) to the general ledger.
(1) Agree applicable amounts from the payables trial balance (aging) and reconciliation

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to the general ledger and trace significant reconciling items, if any, to supporting
documents.

Possible Procedure 2 — Test Payables Owed to Selected Vendors


A. Make an audit sample of vendors or invoices from the payables trial balance (aging). For
each selection, perform the following:
(1) Prepare, or have the entity prepare, confirmation requests for the selected payable
balances. Mail the confirmation requests under our control, determine that the
requests are properly addressed (i.e., obtain audit evidence about the accuracy and
completeness of addresses provided by the entity), and request that all replies be sent
directly to our office.
a. Send second requests for nonreplies.
b. Compare replies to requests. Prepare or have the entity prepare reconciliations
of exceptions. Trace reconciling items to supporting documents.
c. For nonreplies, examine subsequent cash disbursements to the suppliers and/or
unpaid supplier invoices, and receiving records.

Possible Procedure 3 — Test Payables Owed to Selected Suppliers


A. Make an audit sample of vendor invoices from the payables trial balance (aging).
B. Obtain invoice and trace to receiving document, proof of services provided, or other
supporting documentation.

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ACCRUED EXPENSES

ACCOUNT BALANCE ASSERTION — EXISTENCE OF ACCRUED EXPENSES

Possible Procedure 1 — Test Accrued Expenses and Other Liabilities


A. Obtain a list of accrued expenses and other liabilities and test the reconciliation to the
general ledger.
B. Inquire about and/or examine prior-year information concerning the nature of recorded
accrued expenses and other liabilities.
C. For accruals that are based primarily on known data (i.e., that are not accounting
estimates), examine documents supporting the existence of the accrual (e.g., service
contracts, subsequently received invoices, subsequent payroll records, property tax
statements), including the results of subsequent disbursement testing performed on
accounts payable.
D. For accrual estimates related to contingencies (e.g., legal reserves for pending or threatened
litigation, general liability, self-insurance) examine documents supporting the existence of
the accrual such as:
(1) Attorneys’ letters
(2) In-house counsel litigation binders
(3) Insurance policies
(4) Claim data files
(5) Board of directors’ minutes or inquire of key personnel such as:
a. In-house legal counsel
b. Director of Risk Management
c. Operational department leaders.

Possible Procedure 2 — Using Analytical Procedures and/or Tests of Details to


Update Existence Tests Performed at an Interim Date
A. Make inquiries of the entity’s personnel knowledgeable of the accruals recorded at the
interim date regarding their knowledge of any changes in facts or circumstances in the
intervening period that might have a significant impact on the year-end balance.
B. Perform substantive analytical procedures to test the year-end account balance.
(1) Develop expectations of the year-end account balance by considering factors
identified during the interim test as well as changes in facts or circumstances during
the intervening period identified during inquires made.
(2) Determine threshold.
(3) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate

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explanations for the difference by performing further analysis or inquiry and


examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.
And/or:
C. Perform test of details on the account balance change in the intervening period (i.e., from
the interim test date to the balance sheet date) by examining activity within the account
balance.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF ACCRUED


EXPENSES

Possible Procedure 1 — Test Accrued Expense or Other Liability Balances for


Ongoing Pertinence
A. Inquire of management and review information in prior-year working papers concerning
the nature of recorded accruals and identify the specific need for each reserve.
(1) For accruals that have not changed since the prior year-end, assess whether the
circumstances requiring the accruals in the prior year still exist.
B. Inquire of management and obtain an understanding of accruals recorded in the current
year and identify the specific need for each reserve.

Possible Procedure 2 — Identify and Test for Disputed Claims


A. Inquire of members of management, including those independent of the accounting
department (e.g., legal, risk management, purchasing, receiving), as to the existence of
significant disputed claims. For identified items, perform the following:
(1) Obtain audit evidence pertaining to the disputed claim and document our
understanding of the disputed claim.
(2) Determine whether the disputed claim should be included or excluded from the
general ledger at period-end.
(3) Trace disputed claim to appropriate inclusion/exclusion in the period-end general
ledger balance.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF ACCRUED


EXPENSES

Possible Procedure 1 — Perform Tests of Unrecorded Liabilities


A. Inquire of management and review information in the prior-year working papers
concerning the nature of recorded accruals and identify the specific need for each accrual.
B. For the list of accounts utilized in Possible Procedure 1 “Test Accrued Expenses and Other
Liabilities” for Existence above, obtain a rollforward or support for each accrual account,
showing the prior-year balance, any additions, payments, and/or settlements, and the
ending balance.

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(1) If a reduction in the prior-year accrual balance was not due to a specific payment or
disposition, inquire as to the events that triggered the reduction and determine if such
reduction is appropriate.
C. Consider the evidence obtained as part of the search for unrecorded liabilities performed on
accounts payable.
D. For accruals related to contingencies (e.g., legal reserves for pending or threatened
litigation, general liability, self-insurance) to search for unrecorded accruals, examine
supporting documents such as:
(1) Attorneys’ letters
(2) In-house counsel litigation binders
(3) Insurance policies
(4) Claim data files
(5) Board of directors’ minutes, or inquire of key personnel such as:
a. In-house legal counsel
b. Director of Risk Management
c. Operational department leaders.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


ACCRUED EXPENSES

Possible Procedure 1 — Testing Entity’s Methodology for Estimating Accrued


Expenses or Other Liabilities
A. Understand, document, and evaluate the reasonableness of the methods and assumptions
used by management to estimate accrued expenses or other liabilities.
B. If management’s methods and assumptions were reasonable, test the accuracy and
completeness of the data used by management by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures may include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.

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C. Identify and obtain audit evidence to support the key assumptions underlying the estimate.
If management's methods and assumptions are not reasonable, see Possible Procedure 2
“Developing Independent Expectation of Accrued Expenses or Other Liabilities” for
Valuation and Allocation below.
D. In instances when the audit evidence is inconsistent among differing sources, perform
additional audit procedures to resolve the inconsistency.
E. Using the appropriate data, assumptions, and methodology, recompute the accrued expense
or other liability.

Possible Procedure 2 — Developing Independent Expectation of Accrued


Expenses or Other Liabilities
A. Develop a point estimate or range.
B. When developing a point estimate or range, obtain audit evidence to support that the data
used to make our point estimate or range is independent and reliable and, if we are using
information produced by the entity, that it is accurate and complete.
C. When using information that is produced by the entity, obtain audit evidence about the
accuracy and completeness of the data by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures ordinarily include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
D. In instances when the audit evidence to be used in forming our expectations is inconsistent
among differing sources, perform additional audit procedures to resolve the inconsistency.
E. Compare the recorded amount(s) to our point estimate or range and evaluate any
differences. When a point estimate has been developed, the difference between our point
estimate and the recorded estimate constitutes a misstatement. When a range provides
sufficient appropriate audit evidence and the recorded estimate lies outside the range, the
misstatement is no less than the difference between the recorded amount and the nearest
point in the range.

Possible Procedure 3 — Performing Retrospective Review of Significant


Accounting Estimates
A. Perform a retrospective review of significant accounting estimates related to accrued

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expenses and other liabilities of the prior year and consider the results of this retrospective
review in evaluating the current-year estimates. If we identify a possible bias on the part of
management in making accounting estimates, we should evaluate whether circumstances
producing such a bias represent a risk of a material misstatement due to fraud.

Possible Procedure 4 — Test Valuation of Accrued Expenses and Other


Liabilities
A. For accruals tested for the Existence and Completeness assertions of accrued expenses and
other liabilities, test the mathematical accuracy of the supporting evidence, and agree
recorded amounts to the details of the supporting evidence.
B. For accruals for which supporting documentation cannot be located or there are differences
between the accrual and the supporting evidence:
(1) Consider whether the reason for our inability to obtain supporting documentation has
implications related to assessing risks of material misstatement due to fraud, our
planned level of control assurance, or our degree of reliance on management’s
representations.

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NOTES PAYABLE AND LONG-TERM DEBT

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF NOTES PAYABLE


AND LONG-TERM DEBT
Possible Procedure 1 — Test Completeness of Notes Payable and Long-Term
Debt Balances
A. For all cash confirmations to be sent, include a request for outstanding debt balances.
B. Compare replies to general ledger. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.

Possible Procedure 2 — Test Leases of Property, Plant, and Equipment


A. Obtain a schedule of operating leases under which the entity is the lessee, and test
reconciliation to the general ledger.
B. Make inquiries of management and search for any evidence of additional leases (e.g.,
during work performed on payables and operating expenses).
C. Make an audit sample of operating leases from the entity’s schedule and for each selection,
read the lease agreement, and determine that the lease meets the criteria to be accounted for
as an operating lease.
ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF NOTES
PAYABLE AND LONG-TERM DEBT
Possible Procedure 1 —Test Valuation of Foreign Currency
A. Inquire and consider available audit evidence to identify any account balances or
transactions denominated in foreign currencies, and trace currency-translation adjustments
to the general ledger.
B. Agree the exchange rate(s) used to independent published records, and test the translation
calculations.
ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF NOTES
PAYABLE AND LONG-TERM DEBT
Possible Procedure 1 — Test Notes Payable and Long-Term Debt Balances
A. Obtain the notes payable and long-term debt schedule(s) and the reconciliation of the
schedule(s) to the general ledger. Agree applicable amounts from the notes payable and
long-term schedule and reconciliation to the general ledger and trace significant reconciling
items, if any, to supporting documents.
B. Make an audit sample from the schedule of notes payable and long-term debt.
C. Prepare, or have the entity prepare, confirmation requests for the selected debt balances.
Mail the confirmation requests under our control, determine that the requests are properly
addressed (i.e., obtain audit evidence about the accuracy and completeness of addresses
provided by the entity), and request that all replies be sent directly to our office.

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(1) Send second requests for nonreplies.


(2) Compare replies to requests. Prepare or have the entity prepare reconciliations of
exceptions. Trace reconciling items to supporting documents.
(3) For nonreplies, perform alternate procedures (e.g., agree notes payable and long-term
debt to underlying borrowing documents and debt amortization schedules and test
current-year borrowing and payment activity).
Possible Procedure 2 — Review the Cash Reconciliations for Significant
Unreconciled Differences
A. Review the cash reconciliations for the existence of significant unreconciled differences
which could indicate an unrecorded debt payment.
ACCOUNT BALANCE ASSERTION — EXISTENCE OF NOTES PAYABLE AND
LONG-TERM DEBT
Possible Procedure 1 — Test Notes Payable and Long-Term Debt Balances
A. Obtain the notes payable and long-term debt schedule(s) and the reconciliation of the
schedule(s) to the general ledger. Agree applicable amounts from the notes payable and
long-term schedule and reconciliation to the general ledger and trace significant reconciling
items, if any, to supporting documents.
B. Make an audit sample from the schedule of notes payable and long-term debt.
C. Prepare, or have the entity prepare, confirmation requests for the selected debt balances.
Mail the confirmation requests under our control, determine that the requests are properly
addressed (i.e., obtain audit evidence about the accuracy and completeness of addresses
provided by the entity), and request that all replies be sent directly to our office.
(1) Send second requests for nonreplies.
(2) Compare replies to requests. Prepare or have the entity prepare reconciliations of
exceptions. Trace reconciling items to supporting documents.
(3) For nonreplies, perform alternate procedures (e.g., agree notes payable and long-term
debt to underlying borrowing documents and debt amortization schedules and test
current-year borrowing and payment activity).

Possible Procedure 2 — Test Capitalized Leases for Which the Entity Is Lessee
A. Obtain the schedule of capitalized leases in which the entity is a lessee and the
reconciliation of the schedule to the general ledger. Agree applicable amounts from the
schedule of capitalized leases and reconciliation to the general ledger and trace significant
reconciling items, if any, to supporting documents.
B. Make an audit sample from the schedule of capitalized leases.
C. Obtain and read the lease contract or agreement.
D. Prepare, or have the entity prepare, confirmation requests for the selected capitalized lease
balances and contract/agreement terms. Mail the confirmation requests under our control,
determine that the requests are properly addressed (i.e., obtain audit evidence about the

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accuracy and completeness of addresses provided by the entity), and request that all replies
be sent directly to our office.
(1) Send second requests for nonreplies.
(2) Compare replies to requests. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.
(3) For nonreplies, perform alternate procedures (e.g., agree notes payable and long-term
debt to underlying borrowing documents and debt amortization schedules and test
current-year borrowing and payment activity).

Possible Procedure 3 — Using Analytical Procedures and/or Tests of Details to


Update Existence Tests Performed at an Interim Date
A. Inquire into any new debt or capital lease agreements and/or modifications to existing
agreements since the interim date at which notes payable, long-term debt and capitalized
leases were tested and obtain new or modified agreements. Read and document our
understanding of the new or modified agreements.
B. Obtain and review the schedules of debt as of year-end and:
(1) Perform substantive analytical procedures to test the account balance at the end of the
year.
a. Develop expectations of the ending account balance based on the change in the
intervening period considering factors identified during the interim test as well
as those identified during inquires made.
b. Determine threshold.
c. Compare the expectation to the recorded amount and identify any differences.
For any difference that is more than the threshold, obtain, quantify, and
corroborate explanations for the difference by performing further analysis or
inquiry and examining supporting documents. Explanations need to be sought
for the full amount of the difference, not just for the part that exceeds the
threshold.
And/or:
(2) Perform test of details on account balance change in the intervening period (i.e., from
the interim test date to the balance sheet date) by examining activity within the
account balance.

ACCOUNT BALANCE ASSERTION — EXISTENCE, COMPLETENESS,


VALUATION AND ALLOCATION, AND RIGHTS AND OBLIGATIONS OF ACCRUED
INTEREST

Possible Procedure 1 — Test Accrued Interest


A. Obtain a schedule of accrued interest expense (which may be prepared in connection with
the schedule of debt obtained in Possible Procedure 1, “Test Notes Payable and Long-Term
Debt Balances,” within the testing of the Rights and Obligations Assertion above) and test

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the reconciliation to the general ledger.


B. Make an audit sample from the schedule of notes payable and long-term debt instruments.
C. Based on the information in the confirmation obtained (those confirmations obtained in
connection with the test of confirming notes payable and long-term debt balances within
Possible Procedure 1, “Test Notes Payable and Long-Term Debt Balances,” of testing the
Rights and Obligations Assertion above), concerning the date through which interest was
paid and the applicable interest rate, recompute the amount of accrued interest.
D. If the information needed to recompute the amount was not confirmed:
(1) Examine the debt agreement evidencing the interest rate.
(2) Obtain and examine cash disbursement records (usually the paid check) evidencing
the most recent payment of interest.
(3) Recompute the amount of accrued interest.

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EMPLOYEE BENEFIT OBLIGATION


Note: This guide has two sections. Included in the first section are possible procedures that
allow engagement teams to gain an understanding the entity’s benefit plans and related
accounting policies, and evaluating the work of the entity’s actuary. The Possible
Procedures in the first section allow engagement teams to effectively plan and perform
procedures to test the account balances and disclosures at the assertion level. Possible
Procedures to test account balances and disclosures at the assertion level are included in the
second section. Engagement teams may also want to consider the use of the Auditing
Management Estimates: Exploring Leading Practices tool when tailoring appropriate
procedures.

SECTION ONE: UNDERSTANDING THE PLAN AND THE WORK OF THE


ACTUARY

ASSESS THE ABILITY TO USE THE WORK OF THE ENTITY’S ACTUARY


A. Evaluate the qualifications of the actuary by considering the following:
(1) The actuary’s professional certification, license, or membership in an appropriate
professional body.
(2) The actuary’s experience in the type of work under consideration.
(3) The actuary’s reputation in the actuarial field.
B. Evaluate the objectivity of the actuary by performing the following procedures:
(1) Evaluate the relationship of the actuary to the entity and assess the risk that his or her
objectivity might be impaired.
(2) If the actuary has or had a relationship with the entity, perform additional audit
procedures with respect to some or all of the actuary’s assumptions, methods, or
findings to determine that the findings are not unreasonable, or if necessary, consult
with a firm actuary to evaluate the assumptions, methods, or findings.
C. Obtain and document an understanding of the actuary’s scope and objectives, the methods
or assumptions used and, if appropriate, the consistency with those used in the prior period
to understand the nature of the work of the actuary.
D. Conclude on our ability to use the findings of the actuary by considering the results of
Procedures A–C and by performing the following procedures:
(1) Evaluate whether the actuary’s findings are suitable for corroborating management’s
assertions in the financial statements by considering the results of our procedures.
(2) Consider the results of the procedures performed in the Procedures of this section and
the results of testing the underlying data.
(3) If we believe the findings of the actuary are unreasonable, perform additional
procedures with respect to some or all of the actuary’s assumptions, methods, or
findings to determine that the findings are not unreasonable or communicate to

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management that they should engage another actuary.

Read the Plan Information and Accounting Policies to Develop an


Understanding of Actuarial Methods and Assumptions Used to Test
Managements Process Developing Estimates of Employee Benefit Obligation
Balances and Disclosures
A. Obtain and read the plan instruments and related documents to gain an understanding of the
related plans.
B. Read the plan instrument and inquire of management to determine if substantive
commitments that differ from the written plan exist.
C. Obtain and read actuarial information, including a copy of the actuarial report, for each of
the entity’s plans and perform the following:
(1) Obtain an understanding of the plan provisions, significant events, assumptions, etc.
that were considered in determining the measurement of benefit obligation related
amounts.
(2) If not evident from reading the actuarial report, make direct inquiries of the actuary to
determine whether the actuary has considered all significant known events in
determining plan benefit information, such as an acquisition, plant closing,
amendments, terminations, settlements, curtailments, or any other changes that may
affect the entity’s obligation.
(3) If the report contains unusual or unexpected amounts or activity, inquire as to the
nature of the significant items and perform additional procedures as deemed
necessary.
(4) Compare the summary of plan provisions included in the actuarial report or other
information obtained from the actuary to our understanding of plan provisions
obtained by reading the plan instrument and amendments and resolve any
inconsistencies.
(5) If substantive commitments that differ from the written plan were noted as part of our
procedures in Procedure B above, verify that they are considered in the actuarial
measurement.
(6) Determine if the actuarial report contains limitations on the use of the report that
could impact our audit.
D. Obtain and document an understanding of the following:
(1) The assumptions that directly impact the actuarial measurement (i.e., relevant
assumptions) by understanding the benefit formula and other relevant portions of the
plan provisions, inquiring of individuals at the entity that are knowledgeable about
the plan, and/or making direct inquiries of the entity’s actuary. Relevant assumptions
may include discount rates, expected long-term rates of return on plan assets, salary
scale, future compensation, mortality, retirement rate, turnover rate, etc.
(2) The process management uses to select the assumptions used in the actuarial
measurement.

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E. For each relevant assumption used in the measurement of the entity’s benefit obligation and
net periodic benefit obligation cost, read the actuarial report and make inquiries of
management and/or the entity’s actuary to confirm that the following accounting
requirements were considered in the actuarial measurement:
(1) Each assumption represents the entity’s best estimate for that assumption and assumes
the plan will continue in effect in the absence of evidence that it will not. [ASC 715-
30-35-42]
(2) Assumed discount rates reflect the rates at which the benefit obligation benefits could
be effectively settled. [ASC 715-30-35-43]
(3) The expected long-term rate of return on plan assets reflects the average rate of
earnings expected on the funds invested or to be invested to provide for the benefits
included in the projected benefit obligation. [ASC 715-30-35-47]
(4) Assumed future compensation levels are reflected in the actuarial measurement to the
extent that the benefit obligation benefit formula defines benefit obligation benefits
wholly or partially as a function of future compensation levels. [ASC 715-30-35-31]
(5) If the benefit obligation benefit formula is based on future compensation levels,
consider the following in evaluating if estimated future compensation levels are
appropriately considered:
a. Assumed compensation levels reflect future increases in service cost for which
a present substantive commitment exists. [ASC 715-30-35-31 and 35-34]
b. Assumed compensation levels reflect an estimate of the actual future
compensation levels of the individual employees involved, including future
changes attributed to general price levels, productivity, seniority, promotion, and
other factors. [ASC 715-30-35-31]
(6) Automatic benefit increases specified by the plan that are expected to occur are
included in measurements of the projected, accumulated, and vested benefit
obligations and the service cost component. [ASC 715-30-35-35]
(7) All assumptions that reflect expectations of the same future economic conditions,
such as future rates of inflation, are consistent. [ASC 715-30-35-31]
F. Read the actuarial report and make inquiries of management and/or the entity’s actuary to
confirm that the following accounting requirements related to the benefit obligation
calculations were considered in the actuarial measurement.
(1) The accumulated benefit obligation is measured based on employees’ history of
service and compensation without an estimate of future compensation levels. [ASC
715-30-35-2 and 35-32]
(2) The projected years of service are included in measuring the accumulated benefit
obligation, only to determine employees’ eligibility for particular benefits, such as
increased benefits based on a specified number of years of service, early retirement
benefits, death benefits, and disability benefits. [ASC 715-30-35-32]
(3) If the benefit obligation benefit formula is based on future compensation levels, the
projected benefit obligation is measured using an assumption as to those future

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compensation levels. [ASC 715-30-35-1]


(4) The projected benefit obligation is a measurement of benefits attributed to service to
date (assuming that the plan continues in effect and that estimated future events
[including compensation increases, turnover, and mortality] occur). [ASC 715-30-35-
1]
(5) Retroactive plan amendments are included in the computation of the projected and
accumulated benefit obligations once they have been contractually agreed to, even if
some provisions take effect only in future periods. [ASC 715-30-35-35]
G. Read the actuarial report and make inquiries of management and/or the entity’s actuary to
confirm that the following accounting requirements related to the net periodic benefit
obligation cost, prior service cost, and transition obligation calculations were considered in
the actuarial measurement:
(1) The gain or loss component of net periodic benefit obligation costs consists of the
following:
a. The difference between the actual return on plan assets and the expected return
on plan assets.
b. The amortization of the net gain or loss included in accumulated other
comprehensive income (or unrestricted net assets, if the entity is a not-for-
profit). [ASC 715-30-35-22 through 35-26]
(2) The prior service cost or credit has been amortized in accordance with ASC 715-30.
[ASC 715-30-35-4 and 35-10 through 35-17]
(3) The transition net asset or obligation has been amortized in accordance with ASC
715-30. [ASC 715-30-35-4]
H. If we identify any internal accounting policies management has developed by interpreting
accounting pronouncements for entity-specific facts and circumstances that differ from the
policies set forth in the applicable accounting standards, perform the following procedures:
(1) Obtain the entity’s documentation of the internal accounting policy and evaluate the
appropriateness of the entity’s policy.
(2) If the entity’s policy is appropriate, read the actuarial report or make inquiries of the
entity’s actuary to confirm that the policy is communicated to the actuary and is
reflected in the calculation of the benefit obligation balances and disclosures.

Test Accounting Policies When the Entity Has More Than One Defined Benefit
Plan
A. If the entity has two or more defined benefit plans, verify that the net periodic benefit
obligation costs, liabilities, and assets have been determined separately for each plan by
performing the following: [ASC 715-30-25-6]
(1) Obtain and read an actuarial report for each of the plans to determine if each plan has
its own separate measurement of the net periodic benefit obligation costs, liabilities,
and assets.

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Note: Unless the entity has the rights to use the assets of one plan to pay the benefits of
another, the entity should separately determine the net periodic benefit obligation costs
and the recognition of any underfunded benefit obligation liabilities or overfunded benefit
obligation assets as required by ASC 715-30-25-1 for each plan. [ASC 715-30-25-6]

Test Accounting Policies for a Multiemployer Plan


A. If the entity participates in a multiple-employer plan, verify that the entity’s accounting of
such plan (i.e., as either a defined benefit plan or defined contribution plan) is based on its
respective interest in the plan by performing the following: [ASC 715-30-35-70]
(1) Obtain an understanding of the plan by reading the plan instrument and actuarial
report.
(2) Use this understanding to determine if the plan should be accounted for as a defined
benefit plan or a defined contribution plan.
(3) Verify that the entity’s accounting for the plan as a defined benefit plan or defined
contribution plan is consistent with our understanding of the plan.
(4) If the plan is a defined benefit plan, perform procedures in this guide to test the plan.
If the plan is a defined contribution plan, perform procedures contained within the
Accrued Expenses guide above.

Test Accounting Policies for a Cash Balance Plan


A. Verify that the entity’s accounting for the plan is consistent with our understanding of the
plan and ASC 715-30-35-71 by performing the following:
(1) Obtain an understanding of the plan by reading the plan instrument and actuarial
report.
(2) Verify that the entity’s accounting for the plan is consistent with our understanding of
the plan and ASC 715-30-35-71.

Test Accounting Policies for Non-U.S. Plans


A. Determine that non-U.S. plans that are in substance similar to U.S. plans have been
accounted for in accordance with ASC 715-10 by performing the following: [ASC 715-10-
15-6]
(1) Obtain an understanding of the plans by reading plan documents and making inquires
of management and/or the entity’s actuary to determine the substance of the plans.
(2) If the plans are in substance similar to the U.S. plans, perform audit procedures in this
guide to test the plans.
(3) If the plans do not require accounting in accordance with ASC 715-30, perform
procedures to verify that the plans are accounted for appropriately based on the
substance of the plans.

Test Accounting for Annuity Contracts


A. If benefits are covered by an annuity or other insurance contract, verify the accounting

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conforms to the provisions of FASB Statement No. 87, Employers’ Accounting for
Pensions [ASC 715-30], by performing the following: [ASC 715-30-35-53 through 35-61
and 25-7]
(1) Read the contract between the entity and the insurance company.
a. Ascertain if it is irrevocable and if it transfers the obligation to provide certain
benefits to the insurance company.
(2) If the substance of the annuity contract is such that the entity remains subject to all or
most of the risks and rewards associated with the benefit obligation covered or the
assets transferred to the insurance company, verify that the purchase of the contract is
not accounted for as a settlement.
(3) If the purchase of a participating annuity contract constitutes a settlement, verify that
it has been accounted for in accordance with ASC 715-30, including that the
maximum gain (but not the maximum loss) has been reduced by the cost of the
participation right before determining the amount to be recognized in earnings. [ASC
715-30-35-79]

SECTION TWO: ACCOUNT BALANCE AND DISCLOSURE ASSERTION —


SPECIFIC GUIDANCE

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF ACCRUED


EMPLOYEE BENEFIT OBLIGATION COSTS

Possible Procedure 1 — Test Actuary’s Participant Data File for Completeness


A. Obtain a reconciliation of the total number of participants contained in the actuarial report
obtained in the testing of the Existence assertion to the total number of participants in the
actuary output file.
B. Obtain an entity-prepared rollforward of the number of participants by major category
(e.g., active participants (vested and nonvested), terminated vested participants, and retired
participants).
C. Obtain and document an understanding of any significant and/or unexpected increases or
decreases in the number of participants in each of the major categories from the prior year
to the current year. Also consider if there are changes we expected that are not reflected in
the rollforward and investigate.

Possible Procedure 2 — Test Termination Benefits


A. If the entity has provided benefits to employees in connection with employee’s termination
of employment (special termination benefits, offered only for a short period, or contractual
termination benefits, required by the terms of a specified event, such as a plan closing),
verify the following:
(1) For special termination benefits — that the entity has recognized both a liability and a
loss when the employees accepted the offer and the amount can be reasonably
estimated.

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(2) For contractual termination benefits — that the entity has recognized both a liability
and a loss when it is probable that employees will be entitled to benefits and the
amount can be reasonably estimated.
(3) That the entity has included the amount of any lump-sum payments and the present
value of any expected future payments in the cost of termination benefits recognized
as a liability and a loss.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


ACCRUED EMPLOYEE BENEFIT OBLIGATION COSTS

Possible Procedure 1 — Testing Entity’s Assumptions and Methodology for


Estimating
A. Understand, document, and evaluate the reasonableness of the methods and assumptions
used by management to estimate accrued benefit obligation costs.
B. If management’s methods and assumptions were reasonable, test the accuracy and
completeness of the data used by management by either of the following means:
(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures may include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
C. Identify and obtain audit evidence to support the key assumptions underlying the estimate.
D. In instances when the audit evidence is inconsistent among differing sources, perform
additional audit procedures to resolve the inconsistency.
E. Using the appropriate data, assumptions, and methodology, recompute the accrued benefit
obligation costs.

Possible Procedure 2 — Developing an Independent Expectation of Accrued


Employee Benefit Obligation Costs
A. Develop a point estimate or range.
B. When developing a point estimate or range, obtain audit evidence to support that the data
used to make our point estimate or range is independent and reliable and if we are using
information produced by the entity, that it is accurate and complete.
C. When using information that is produced by the entity, obtain audit evidence about the

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accuracy and completeness of the data by either of the following means:


(1) Perform tests of the operating effectiveness of controls over the production and
maintenance of the information. [Note: Tests of the operating effectiveness of general
computer controls alone do not provide assurance over the accuracy and
completeness of information produced by the entity.]
(2) Perform audit procedures directly on the information being relied upon. These
procedures ordinarily include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information (e.g., ACL).
b. Agreeing summary information to underlying data or third-party source
documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
D. In instances when the audit evidence to be used in forming our expectations is inconsistent
among differing sources, perform additional audit procedures to resolve the inconsistency.
E. Compare the recorded amount(s) to our point estimate or range and evaluate any
differences. When a point estimate has been developed, the difference between our point
estimate and the recorded estimate constitutes a misstatement. When a range provides
sufficient appropriate audit evidence and the recorded estimates lies outside the range, the
misstatement is no less than the difference between the recorded amount and the nearest
point in the range.

Possible Procedure 3 — Performing Retrospective Review of Significant


Accounting Estimates
A. Perform a retrospective review of significant accounting estimates related to accrued
benefit obligation costs of the prior year and consider the results of this retrospective
review in evaluating the current-year estimates. If we identify a possible bias on the part of
management in making accounting estimates, we should evaluate whether circumstances
producing such a bias represent a risk of a material misstatement due to fraud.

Possible Procedure 4 — Testing Underlying Data Used by the Entity’s Actuary


A. Obtain and document an understanding of the procedures used by the entity to determine
that the information provided to and used by the actuary, when performing their
measurement, is accurate and complete. If the procedures are not appropriate and we
determine that a deficiency exists, evaluate the deficiency and consider whether we need to
amend our planned substantive procedures.
B. Obtain and document an understanding of the participant data that is relevant to the
actuarial measurement by performing the following:
(1) Gain an understanding of the date that the entity provides the census data to the
actuary (e.g., beginning or end of year).
(2) Gain an understanding of the participant data (e.g., age, gender, years of service,
compensation) that directly impacts the actuarial measurement by reading the plan

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provisions, inquiring of individuals at the entity that are knowledgeable about the
plan, or making direct inquiries of the entity’s actuaries.
a. For the selection made in Possible Procedure 2 for the testing of the Existence
assertion, agree demographic information to the participant’s personnel file.
C. Test any significant changes the actuary may have made to the participant data provided by
the entity to the actuary in generating the actuary output file discussed in the introduction
to this guide by performing the following procedures:
(1) Make inquiries of the entity’s actuary to understand the changes that the actuary made
to the census data received from the entity. This may include data analysis (e.g.,
thresholds, filters) to check the data for reasonability and to check the types and
extent of changes from year to year.
(2) Obtain a reconciliation of the census data the entity sent the actuary to the actuary
output file.
(3) Develop procedures to test the changes as appropriate based on our understanding of
the nature and extent of the changes.
D. Test the accuracy of the actuary output file by performing the following procedures:
(1) Obtain a reconciliation of the total number of participants contained in the actuarial
report to the total number of participants in the actuary output file.
(2) Obtain an entity-prepared rollforward of the number of participants by major category
(e.g., active participants (vested and nonvested), terminated vested participants, and
retired participants) and perform the following:
a. Agree beginning balances to the prior-year working papers and ending balances
to the reconciliation in Step D(1) above.
b. Obtain and document an understanding of any significant and/or unexpected
increases or decreases in the number of participants in each of the major
categories (e.g., active participants, terminated vested participants, and/or
retired participants) from the prior year to the current year. Also consider if
there are changes we expected that are not reflected in the rollforward.

Possible Procedure 5 — Test Accumulated and Projected Benefit Obligations


A. Based on the understanding obtained of the plan, develop an independent expectation of
accumulated and projected benefit obligations. Refer to “Valuation and Allocation Possible
Procedure 2 — Developing Independent Expectation of Accrued Employee Benefit
Obligation Costs” for further considerations for developing an independent expectation of
the accumulated and projected benefit obligation and consider the following:
(1) How benefits are attributed to the periods of employee service according to the
benefit plan formula.
(2) Changes in demographic data and related assumptions, including but not limited to,
early retirement, turnover, and mortality assumptions.
(3) Discount rate.

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(4) Change in compensation levels from the prior year, if the benefit obligation benefit
formula is based on compensation.
(5) Employees’ history of service and compensation without an estimate of future
compensation levels. [ASC 715-30-35-2 and 35-32]
(6) Projected years of service only to determine employees’ eligibility for particular
benefits, such as increased benefits based on a specified number of years of service,
early retirement benefits, death benefits, and disability benefits. [ASC 715-30-35-32]

Possible Procedure 6 — Test Net Periodic Employee Benefit Obligation Cost


A. Based on the understanding obtained of the plan, develop an independent expectation of net
periodic benefit obligation cost. Refer to “Valuation and Allocation Possible Procedure 2
— Developing Independent Expectation of Accrued Employee Benefit Obligation Costs”
for further considerations for developing an independent expectation of the net periodic
benefit obligation cost and consider the following:
(1) How benefits are attributed to the periods of employee service according to the
benefit plan formula
(2) Changes in the projected benefit obligation
(3) Actual return on plan assets
(4) Amortization of net gains or losses, prior-service costs, and/or transition obligation
(5) Consider disaggregating the account balance into the components to develop a
meaningful expectation and test footnote disclosures.

Possible Procedure 7 — Test Unrecognized Net Gains and Losses


A. Based on the understanding obtained of the plan, develop an independent expectation of
unrecognized net gains and losses. Refer to “Valuation and Allocation Possible Procedure 2
— Developing Independent Expectation of Accrued Employee Benefit Obligation Costs”
for further considerations for developing an independent expectation of the unrecognized
net gains and losses and consider the following:
(1) Changes in the projected benefit obligation
(2) The difference between actual and expected return on plan assets
(3) The minimum amount of amortization of gains or losses required as by ASC 715-30-
35-24.

Possible Procedure 8 — Test Unrecognized Prior Service Costs


A. Based on the understanding obtained of the plan, develop an independent expectation of
unrecognized prior service costs. Refer to “Valuation and Allocation Possible Procedure 2
— Developing Independent Expectation of Accrued Employee Benefit Obligation Costs”
for further considerations for developing an independent expectation of the unrecognized
prior service costs and consider the following:
(1) The beginning balance, if any

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(2) Amortization of existing prior service cost or credit in accordance with ASC 715-30.
[ASC 715-30-35-4 and 35-10 through 35-17]
(3) Additional prior-service cost or credit recorded in the current year (e.g., those
resulting from plan amendments).
B. If any new prior-service costs or credits were recorded in the current year, develop tailored
procedures to test the new costs.

Possible Procedure 9 — Test Unrecognized Transition Asset or Obligation


A. Based on the understanding obtained of the plan, develop an independent expectation of
unrecognized transition asset or obligation. Refer to “Valuation and Allocation Possible
Procedure 2 — Developing Independent Expectation of Accrued Employee Benefit
Obligation Costs” for further considerations for developing an independent expectation of
the unrecognized prior-service costs and consider the following:
(1) The beginning balance
(2) Amortization of the transition obligation in accordance with ASC 715-30.

ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF ACCRUED


EMPLOYEE BENEFIT OBLIGATION COSTS

Possible Procedure 1 — Test the Rights and Obligations of Plan Assets and
Liabilities
A. Inquire of management, review the minutes of the human resource committee and of those
charged with governance, and utilize knowledge obtained through the audit of the entity to
determine whether there have been any events that would remove the plan’s right to an
asset or relieve a previous liability.
B. If any event, as described in Step A above is identified, obtain appropriate audit evidence
so that the related asset and/or liability associated with the plan has been adjusted
accordingly.

ACCOUNT BALANCE ASSERTION — EXISTENCE OF ACCRUED EMPLOYEE


BENEFIT OBLIGATION COSTS

Possible Procedure 1 — Obtain Confirmation from the Entity’s Actuary


A. Obtain written confirmation from the actuary (see Form 663*A, Illustrative Confirmations
— Actuarial Inquiries, available on the U.S. Technical Library) of the following:
(1) Requesting information for each benefit obligation plan, including a copy of the
actuarial report and footnote disclosures for each plan.
(2) Requesting a summary directly from the actuary of participant information by major
category (e.g., active employees, terminated vested participants, retired participants).
(3) Requesting the final data file that the actuary used in performing his or her
measurement (“actuary output file”) as of the census date.

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a. Gain an understanding of the date that the entity provides the census data to the
actuary (e.g., beginning or end of year).
b. Make inquiries of the entity’s actuary to understand the changes that the actuary
made to the census data receive from the entity. This may include data analysis
(e.g., thresholds, filters) to check the data for reasonability and to check the
types and extent of changes from year to year.
c. Obtain a reconciliation of the census data the entity sent the actuary to the
actuary output file.
d. Develop procedures to test the changes as appropriate based on our
understanding of the nature and extent of the changes.
(4) Confirming that the actuary communicated all changes in underlying participant data
to the entity.
B. Agree the amounts in the confirmation to those recorded in the general ledger and the
footnote disclosures.

Possible Procedure 2 — Test Current-Year Participant Eligibility


A. Obtain a listing of participants from plan records by major category (e.g., active
participants (vested and nonvested), terminated vested participants, and retired participants)
and perform the following:
(1) Make an attribute sample of individuals from the listing included in the actuarial
report. Verify that the individuals that are participating in the plan meet eligibility
requirements.

Possible Procedure 3 — Test for Modifications to the Benefit Plan Structure


A. Inquire of management, review the minutes of the human resource committee and of those
charged with governance to identify if the entity modified or terminated existing plans or
created new plans that may affect the benefit plan structure.
B. If any event, as described in Step A above, is identified, obtain appropriate audit evidence
so that the related asset and/or liability associated with the plan has been adjusted
accordingly.

ACCOUNT BALANCE ASSERTIONS — EXISTENCE, RIGHTS AND


OBLIGATIONS, AND VALUATION AND ALLOCATION OF ACCRUED EMPLOYEE
BENEFIT OBLIGATION COSTS AND OCCURRENCE, ACCURACY, AND
COMPLETENESS OF EMPLOYEE BENEFIT OBLIGATION EXPENSE

Possible Procedure 1 — Test Settlements of Projected Benefit Obligations


A. If the entity made a lump-sum cash payment to plan participants in exchange for their
rights to receive specified benefit obligation benefits or otherwise enter into a transaction
that may indicate a full or partial settlement of its projected benefit obligations, determine
whether the transaction meets all of the criteria of a settlement as set forth in “ASC Master
Glossary-Settlement” by performing the following:

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(1) Obtain an understanding of the transaction and obtain supporting documentation.


(2) Assess whether the transaction constitutes a full or partial settlement. Consider the
implementation guidance in ASC 715-30-55-140 through 55-159.
(3) Evaluate if the entity’s determination of whether the transaction is a settlement is
consistent with our assessment obtained in understanding the plan documents and
actuarial methods and assumptions.
B. If the transaction results in a settlement of the entity’s projected benefit obligations,
perform the following:
(1) Verify that the maximum gain or loss includes any net gain or loss remaining in
accumulated other comprehensive income (or unrestricted net assets, if the entity is a
not-for-profit) plus any transition asset remaining in accumulated other
comprehensive income (or unrestricted net assets, if the entity is a not-for-profit).
[ASC 715-30-35-79]
a. If the entire projected benefit obligation was settled, verify that the maximum
amount was recognized by the entity. [ASC 715-30-35-79]
b. If only part of the projected benefit obligation was settled, verify that only a pro
rata portion of the maximum amount, equal to the percentage reduction in the
projected benefit obligation, has been recognized by the entity. [ASC 715-30-
35-79]
(2) If the costs of all settlements in a year, including those resulting from the purchase of
a nonparticipating annuity contract, are less than or equal to the sum of the service
and interest cost components for the year, verify that the accounting policies the
entity adopted for recognition of settlement gains and losses are applied consistently
from year to year.

Possible Procedure 2 — Test Curtailments


A. If there is an event that (a) significantly reduces the expected years of future service of
present employees or (b) eliminates for a significant number of employees, the accrual of
defined benefits for some or all of their future services, determine whether a curtailment
has occurred by performing the following: [ASC 715-30-15-6]
(1) Obtain an understanding of the event and obtain supporting documentation.
(2) Assess the “significance” of the event to determine if a curtailment has occurred.
(3) Evaluate if the entity’s determination of whether the event is a curtailment is
consistent with our assessment obtained in understanding the plan documents and
actuarial methods and assumptions.
B. If the event results in a curtailment, evaluate if the entity’s accounting for the settlement
meets the following accounting requirements:
(1) The projected benefit obligation has been increased (loss) or decreased (gain) by the
effects of the curtailment. [ASC 715-30-35-93]
a. Any transition asset remaining in accumulated other comprehensive income (or

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unrestricted net assets, if the entity is a not-for-profit) has been treated as a net
gain for this purpose and combined with the net gain or loss arising after the
transition of FASB Statement 87 remaining in accumulated other
comprehensive income (or unrestricted net assets, if the entity is a not-for-
profit). [ASC 715-30-35-93]
b. If applicable, the increase (loss) in the benefit obligation has first been offset
against any gain as measured in Step B(1)(a) above, and whether any excess
loss has been treated as a curtailment loss. [ASC 715-30-35-93]
c. If applicable, the decrease (gain) in the benefit obligation has first been offset
against any loss as measured in Procedure B(1)(a) above, and whether any
excess gain has been treated as a curtailment gain. [ASC 715-30-35-93]
(2) The net loss or gain calculated in Steps B(1)(b) or B(1)(c) above has been combined
with the prior-service cost loss. [ASC 715-30-35-93]
a. If the total determined in Step B(2) above results in a net loss, verify it has been
recognized by the entity when it is probable that a curtailment will occur and the
net effect is reasonably estimable. [ASC 715-30-35-94]
b. If the total determined in Step B(2) above results in a net gain, verify it has been
recognized when the related employees terminated or the plan suspension or
amendment was adopted. [ASC 715-30-35-94]
(3) The prior-service costs included in accumulated other comprehensive income (or
unrestricted net assets, if the entity is a not-for-profit) and associated with years of
service no longer expected to be rendered has been recognized as a loss. [ASC 715-
30-35-92]
(4) The prior-service cost includes the cost of retroactive amendments and any transition
obligation remaining in accumulated other comprehensive income (or unrestricted net
assets, if the entity is a not-for-profit). [ASC 715-30-35-92]

Possible Procedure 3 — Test Employee Benefit Obligation Accounting Related


to the Disposal of a Component
A. Verify that the gain or loss from a settlement or a curtailment that is directly related to the
disposal of a component of an entity is reported appropriately by performing the following:
[ASC 715-30-35-94]
(1) Verify the gain or loss on a settlement or curtailment that is directly related to the
disposal of a component of an entity is included in determining the gain or loss
associated with the disposal event. [ASC 205-20-45-4 through 45-5]
B. If termination benefits are directly related to disposal of a component of an entity, verify
that the entity has included such costs in determining the gain or loss associated with the
disposal. [ASC 205-20-45-4 through 45-5]
C. For other procedures related to costs associated with exit or disposal activities, see
procedures in the Accrued Expense guide above.

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Possible Procedure 4 — Test Current Year Contribution Activity


A. Obtain a reconciliation of beginning to ending balances of the fair value of plan assets
showing separately the effects during the period attributable to each of the following, as
applicable: actual return on plan assets, foreign currency exchange rate changes,
contributions by the employer, contributions by plan participants, benefits paid, business
combinations, divestitures, and settlements.
(1) Agree the beginning balances to the prior-year working papers and agree the ending
balances to the general ledger.
(2) Use ACL (or another method if more efficient) to test the summarization of the
reconciliation.
(3) Use substantive analytical procedures or tests of detail to test the current year
contribution activity.
(4) Agree the reconciliation to the financial statements. Trace significant reconciling
items, if any, to supporting documents.
B. Evaluate the results of the tests.

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INCOME TAXES
Note: Given the nature of income tax accounts (i.e., many procedures are interrelated to both
the income tax expense and deferred taxes), the procedures are currently presented in the order
that the audit procedures are performed. Therefore, they are not sorted by income tax expense
and deferred taxes.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF INCOME TAX


EXPENSE AND DEFERRED TAXES

Possible Procedure 1 — Test Completeness of Permanent and Temporary


Adjustments to Book Income
A. Obtain a schedule showing the calculation of the current year provision for income taxes.
For each legal entity or tax group in each tax jurisdiction that is determined to be
significant by the audit engagement team, perform the following:
(1) Test the completeness of permanent and temporary differences considering permanent
and temporary differences recorded on the prior-year tax return by selecting debits to
taxable income from the Schedule M1 or Schedule M3, and determine that for those
selections that there is a corresponding deferred tax liability recorded.
(2) Review the current year general ledger for account balances that may have a
permanent or temporary difference between book treatment and tax treatment.
(3) Determine that items representing permanent or temporary differences between
current taxable income and financial reporting pretax income have resulted from
events recognized in the financial statements that do not have tax consequences or
vice versa.

ACCOUNT BALANCE ASSERTION — OCCURRENCE AND ACCURACY OF


INCOME TAX EXPENSE AND EXISTENCE AND VALUATION AND ALLOCATION
OF DEFERRED TAXES

Possible Procedure 1 — Test Occurrence and Accuracy of Permanent and


Temporary Adjustments to Book Income and Existence and Valuation and
Allocation of Deferred Taxes Using Analytical Procedures
A. Obtain a schedule of the adjustments made to book income for permanent and temporary
differences to arrive at taxable income for each legal entity or tax group in each tax
jurisdiction that is determined to be significant by the audit engagement team, and perform
the following to test permanent and temporary differences:
(1) Consider the following data to develop expectations of the tax-effected permanent or
temporary tax differences:
a. The prior-year balance
b. Expected changes due to current-year activity
c. Information obtained from prior-year tax returns.

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(2) Determine that the data used to develop our expectation is independent and reliable
and will provide a plausible and predictable relationship to the account balance being
tested.
(3) Determine the threshold for identifying differences between the expectations and the
recorded amount that is acceptable without further investigation.
(4) Compare the expectations to the recorded amounts and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents.

Possible Procedure 2 — Test Occurrence and Accuracy of Permanent and


Temporary Adjustments to Book Income and Existence and Valuation and
Allocation of Deferred Taxes Using Test of Details
A. Obtain a schedule of the adjustments made to book income for permanent and temporary
differences to arrive at taxable income for each legal entity or tax group in each tax
jurisdiction that is determined to be significant by the audit engagement team, and perform
the following to test permanent and temporary differences:
(1) Make an audit sample of tax-effected permanent and temporary differences on the
absolute value of permanent items.
(2) Test the end-of-year tax basis balance and agree the amount to either a tax-basis
balance sheet (if the entity maintains a tax-basis balance sheet) or other supporting
tax-basis working papers, if applicable.
(3) Recompute differences between end-of-year financial statement balances and end-of-
year tax-basis balances and agree the recomputed difference to the entity’s schedule
of permanent and temporary differences.

ACCOUNT BALANCE ASSERTION — ACCURACY OF INCOME TAX EXPENSE


AND VALUATION AND ALLOCATION OF INCOME TAXES PAYABLE/RECEIVABLE

Possible Procedure 1 — Test Accuracy of Income Tax Expense and Valuation


and Allocation of Income Taxes Payable/Receivable
A. Obtain a schedule of the adjustments made to book income for permanent and temporary
differences to arrive at taxable income for each legal entity or tax group in each tax
jurisdiction that is determined to be significant by the audit engagement team, and perform
the following to test permanent and temporary differences:
(1) Test the schedule for mathematical accuracy.
(2) Agree pretax income in the schedule to the entity’s income statement.
(3) Recompute the amount of income tax expense or benefit based on taxable income
considering, as applicable:
a. Tax rates agreed to the rates established by the tax authority or to another
independent source.

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b. Tax credits, tested as to propriety, with the amount based on the relevant tax
law and the underlying data.

ACCOUNT BALANCE ASSERTION — OCCURRENCE AND COMPLETENESS OF


INTERCOMPANY TRANSACTIONS ON INCOME TAX EXPENSE (BENEFIT)

Possible Procedure 1 — For Transactions with Transfer Pricing Considerations,


Test Occurrence and Completeness of Income Tax Expense (Benefit) of Income
Tax Expense
A. Obtain management’s schedule summarizing all material related-party transactions,
including details of the type of transaction, the parties involved, and the value or volume of
the transaction flows (consider whether to request that the entity summarize all material
related-party transactions and related details on the Transfer Pricing Worksheet included as
Appendix A to this Form). Test completeness of the schedule by performing the following:
(1) Make inquiries of appropriate entity personnel about material related-party
transactions and determine that the transactions discussed are reflected on the
schedule, including consideration of significant valuable intangibles licensed (or
used) by an affiliate; marketing, managerial, administrative, technical, or other
services provided to (or by) an affiliate; and financing (e.g., loans, advances,
guarantees) provided to (or by) an affiliate.
(2) Compare the related-party transactions reflected on the schedule for the current year
to those reported in the prior year’s income tax return (e.g., U.S. Federal Income Tax
Forms 5471 or 5472) and determine the reasons for any significant changes.
(3) Based on evidence obtained during the performance of other auditing procedures,
consider whether there are additional material related-party transactions not reflected
on the schedule.
B. Make an audit sample of related-party transactions included in the schedule and perform
the following:
(1) Agree the amounts of the selected transactions to the general ledger.
(2) Gather and evaluate the evidence in support of the transaction and whether the
transaction was recorded between the entity and the related party at the appropriate
amount.

ACCOUNT BALANCE ASSERTION — CLASSIFICATION OF INCOME TAX


EXPENSE

Possible Procedure 1 — Test Classification of Income Tax Expense


A. Obtain a schedule allocating income tax expense or benefit for the year among continuing
operations, discontinued operations, extraordinary items, and items charged or credited
directly to shareholders’ equity and test that the allocation of income tax expense is
appropriate.

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ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


DEFERRED TAXES

Possible Procedure 1 — Test Valuation and Allocation of Deferred Taxes —


Appropriate Tax Rates Applied to Calculate Tax-Effected Deferred Tax Balances
A. Obtain a rollforward schedule of the temporary differences by significant tax jurisdiction
and perform the following:
(1) Test the mathematical accuracy of the schedule.
(2) Agree the ending balance to the general ledger.
(3) Test the tax rates used to calculate or measure deferred items by significant
jurisdiction by agreeing the tax rates are the rate(s) expected to apply to taxable
income in the years that the liability is expected to be settled or the asset recovered
are in agreement with the tax rates applicable in the jurisdiction.
(4) Test the mathematical accuracy of the application of the tax rates to the gross deferred
tax balances in arriving at the tax-effected deferred tax balances.
(5) Test the classification of deferred taxes into current and noncurrent deferred tax assets
and liabilities by jurisdiction is appropriate.

Possible Procedure 2 — Test Valuation and Allocation of Deferred Taxes —


Permanently Reinvested Foreign Earnings
A. Determine whether a deferred tax liability has not been recognized for the excess of the
amount for financial reporting over the tax basis of an investment in a foreign subsidiary or
joint venture or undistributed earnings of a foreign subsidiary or joint venture that is
permanent in duration.
(1) For earnings that are designated by the entity as permanently reinvested, test whether
this designation is consistent with:
a. History of not transferring earnings back to the home jurisdiction of the legal
entity
b. The entity’s plans for reinvesting the foreign earnings.

Possible Procedure 3 — Test Valuation and Allocation of Deferred Taxes —


Testing the Entity’s Process and Methodology for Determining the Need for and
Amount of a Valuation Allowance
A. Understand, document, and evaluate the reasonableness of the methods and assumptions
management used to determine whether a valuation allowance is necessary and if so, the
methods and assumptions management used to determine the valuation allowance.
B. Considering the positive and negative evidence in management’s assessment and evidence
obtained through other audit procedures, determine whether a valuation allowance is
necessary and if the amount is appropriate (i.e., sufficient to reduce the deferred tax asset to
an amount that is more likely than not to be realized). Consider whether the weight given to

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the potential effect of negative and positive evidence has been commensurate with the
extent to which it can be objectively verified.
C. In determining that a valuation allowance is not necessary, consider the following examples
of negative evidence:
(1) Cumulative losses in recent years
(2) History of operating loss or tax credit carryforwards expiring unused
(3) Losses expected in early future years
(4) Unsettled circumstances that, if unfavorably resolved, would adversely affect future
operations and profit levels on a continuing basis in future years
(5) A carryback or carryforward period that is so brief that it would limit realization of
tax benefits if a significant deductible temporary difference is expected to reverse in a
single year, or the enterprise operates in a traditionally cyclical business.
D. Before determining that a valuation allowance is necessary, consider the four possible
sources of taxable income available under the tax law to realize a deferred tax benefit for
deductible temporary differences and carryforwards:
(1) Future reversals of existing taxable temporary differences
(2) Future taxable income exclusive of reversing temporary differences and
carryforwards
(3) Taxable income in prior carryback year(s) if carryback is permitted under the tax law
(4) Tax planning strategies that are prudent and feasible, which, if implemented, would
permit the realization of deferred tax assets, before the expiration of the carryforward
period.
E. Obtain support for a conclusion that a valuation allowance is not needed when there is
negative evidence. Consider the positive evidence that may include (but is not limited to)
the following examples:
(1) Existing contracts or firm sales backlog that will produce more than enough taxable
income to realize the deferred tax asset based on existing sales prices and cost
structures.
(2) An excess of appreciated asset value over the tax basis of the entity’s net assets in an
amount sufficient to realize the deferred tax asset.
(3) A strong earnings history exclusive of the loss that created the future deductible
amount (tax loss carryforward or deductible temporary difference) coupled with
evidence indicating that the loss is an aberration rather than a continuing condition.
F. If management’s methods were reasonable, test the accuracy and completeness of the data
used by management by either of the following means:
(1) Perform audit procedures directly on the information being relied upon. These
procedures may include either of the following:
a. Reproducing the information, using the entity’s underlying data and file-
interrogation software on computer-generated information.

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b. Agreeing summary information to underlying data or third-party source


documents and tracing a selection of information from the entity’s underlying
data or third-party source documents into the information.
(2) Indentify and obtain audit evidence to support the key assumptions underlying the
estimate.
(3) In instances when the audit evidence is inconsistent among differing sources, perform
additional audit procedures to resolve the inconsistency.
(4) Using the appropriate data, assumptions, and methodology, recompute the valuation
allowance.
G. Determine that the total valuation allowance is sufficient to reduce the deferred tax asset to
the amount that is more likely than not to be realized.
H. Consider whether the significant assumptions utilized by management in concluding
whether a valuation allowance is necessary and if the significant assumptions utilized by
management have significantly changed from those used in the prior year or based on
historical experience that may indicate management bias.

Possible Procedure 4 — Test Valuation and Allocation of Deferred Taxes —


Develop an Independent Expectation of the Valuation Allowance
A. Considering the positive and negative evidence in management’s assessment and evidence
obtained through other audit procedures, determine whether a valuation allowance is
necessary and the amount is appropriate (i.e., sufficient to reduce the deferred tax asset to
an amount that is more likely than not to be realized). Consider whether the weight given to
the potential effect of negative and positive evidence has been commensurate with the
extent to which it can be objectively verified.
B. In determining that a valuation allowance is not necessary, consider the following examples
of negative evidence:
(1) Cumulative losses in recent years
(2) History of operating loss or tax credit carryforwards expiring unused
(3) Losses expected in early future years
(4) Unsettled circumstances that, if unfavorably resolved, would adversely affect future
operations and profit levels on a continuing basis in future years
(5) A carryback or carryforward period that is so brief that it would limit realization of
tax benefits if a significant deductible temporary difference is expected to reverse in a
single year, or the enterprise operates in a traditionally cyclical business.
C. Before determining that a valuation allowance is necessary consider the four possible
sources of taxable income available under the tax law to realize a deferred tax benefit for
deductible temporary differences and carryforwards:
(1) Future reversals of existing taxable temporary differences
(2) Future taxable income exclusive of reversing temporary differences and
carryforwards

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(3) Taxable income in prior carryback year(s) if carryback is permitted under the tax law
(4) Tax planning strategies that are prudent and feasible that could, if necessary, be
implemented utilize expiring carryforward.
D. Obtain support for a conclusion that a valuation allowance is not needed when there is
negative evidence. Consider the positive evidence that may include (but is not limited to)
the following examples:
(1) Existing contracts or firm sales backlog that will produce more than enough taxable
income to realize the deferred tax asset based on existing sales prices and cost
structures
(2) An excess of appreciated asset value over the tax basis of the entity’s net assets in an
amount sufficient to realize the deferred tax asset
(3) A strong earnings history exclusive of the loss that created the future deductible
amount (tax loss carryforward or deductible temporary difference) coupled with
evidence indicating that the loss is an aberration rather than a continuing condition.
E. Perform audit procedures directly on the information being relied upon. These procedures
may include either of the following:
(1) Reproducing the information, using the entity’s underlying data and file-interrogation
software on computer-generated information
(2) Agreeing summary information to underlying data or third-party source documents
and tracing a selection of information from the entity’s underlying data or third-party
source documents into the information.
F. In instances when the audit evidence is inconsistent among differing sources, perform
additional audit procedures to resolve the inconsistency.
G. Develop an independent range of reasonable estimates of the valuation allowance and
determine whether management’s estimate falls within that range.
H. Consider whether the significant assumptions utilized by management in concluding
whether a valuation allowance is necessary and if the significant assumptions utilized by
management have significantly changed from those used in the prior year or based on
historical experience that may indicate management bias.

ACCOUNT BALANCE ASSERTION — CUTOFF OF INCOME TAX EXPENSE

Possible Procedure 1 — Test Cutoff for Return to Accrual Adjustments and


Their Potential Effect on Income Tax Expense (Benefit) and Valuation and
Allocation for Return to Accrual Adjustments and Their Potential Effect on
Deferred Taxes
A. Make an audit sample using the appropriate sampling interval of items in the rollforward
schedule of tax accounts that represent an adjustment to update the prior-year tax provision
to the prior-year tax return (i.e., a return to provision adjustment) and perform the
following:

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(1) Trace the return amount to the tax return and the provision amount to prior-year’s
income tax provision.
(2) Determine whether the return to provision adjustment is an error or a change in
estimate by considering:
a. Whether management consider all of the information available at the time the
prior-year provision was prepared
b. When the information that indicated the need for an adjustment became
available
(3) Consider whether any of the return to accrual adjustments are indicative of
management bias in preparing the prior-year income tax provision.

ACCOUNT BALANCE ASSERTION — ACCURACY OF INCOME TAX EXPENSE


(BENEFIT) AND VALUATION AND ALLOCATION OF DEFERRED TAXES

Possible Procedure 1 — Test Income Tax Account Balances Allocated to


Separate Financial Statements of a Subsidiary
A. Obtain a schedule that allocates the consolidated amount of current and deferred tax
expense for a group that files a consolidated tax return among the members of the group
when those members issue separate financial statements and perform the following:
(1) Determine that the allocation methodology used is systematic, rational, and consistent
with the broad principles established by ASC 740, Income Taxes.
(2) Test the mathematical accuracy of the schedule and recompute the allocations using
the allocation methodology.
B. If the entity is a member of a group that files a consolidated tax return, determine that the
following is disclosed in its separately issued financial statements:
(1) The aggregate amount of current and deferred tax expense for each statement of
earnings presented and the amount of any tax-related balances due to or from
affiliates as of the date of each statement of financial position presented.
(2) The principal provisions of the method by which the consolidated amount of current
and deferred tax expense is allocated to members of the group and the nature and
effect of any changes in that method (and in determining related balances to or from
affiliates) during the years for which the disclosures in the above item is presented.

ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF


INCOME TAXES PAYABLE/RECEIVABLE

Possible Procedure 1 — Test Income Taxes Payable/Receivable


A. Obtain a rollforward schedule by tax jurisdiction of income tax accounts and perform the
following:
(1) Test the schedule for completeness of the tax jurisdictions included therein by
performing the following:

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a. Make inquiries of management and obtain corroborating evidence as to any new


tax jurisdictions in which the entity operates and obtain corroborating evidence
by obtaining copies of the most recently filed tax returns and reconcile
jurisdictions identified therein to the schedule.
b. Test the mathematical accuracy of the schedule and agree the beginning
balances to prior year working papers and the ending balances and current-year
provisions to the general ledger.
B. Make an audit sample of current year payments and receipts shown in the rollforward
schedule obtained in Step A(1) and vouch the payments selected.
(1) For payment of prior-year taxes, agree the amount of the prior-year tax return.
(2) For payment of current-year estimated payment, agree the amount to the schedule of
current-year estimated tax payments included in the determination of the current-year
income taxes payable/receivable.
(3) For receipts, agree the amounts to the related tax returns.
a. For income taxes receivable with no current year activity inquire as to the status
of the refunds filed for, but not received, and assess the valuation of the
amounts recorded.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF UNCERTAIN TAX


POSITIONS

Possible Procedure 1 — Test Completeness of Uncertain Tax Positions Which


Affects the Uncertain Tax Position Liability and Income Tax Expense (Benefit)
A. Obtain the entity’s listing of uncertain tax positions and test the listing for completeness by
performing the following:
(1) Review prior-year tax returns for tax years that remain subject to examination by a
taxing authority to identify any uncertain tax positions.
(2) Review general ledger accounts for items that would give rise to unrecognized tax
benefits and discuss the nature of the accounts with the audit engagement team and/or
the entity.
(3) Determine that unrecognized tax benefits identified from the above procedures, if
any, are included on the entity’s listing of uncertain tax positions.
B. Inquire as to changes to the organizational structure during the period of all open tax years
that could create new uncertain positions in the current year.
C. If we determine that a significant tax jurisdiction is not included in the schedule, perform
Step D.
D. Perform additional procedures to obtain reasonable assurance that all significant uncertain
tax positions in that jurisdiction are identified.

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ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION AND


ACCURACY OF UNCERTAIN TAX POSITIONS

Possible Procedure 1— Test Valuation and Allocation and Accuracy of Uncertain


Tax Positions Which Affect the Uncertain Tax Position Liability and Income Tax
Expense (Benefit)
A. Obtain a schedule of uncertain tax positions and make a selection of uncertain tax positions
for which the detailed information included in the entity’s summary rollforward schedule of
all amounts recorded for unrecognized tax benefits will be tested and perform the
following:
(1) Determine that the selected unit of account was at an appropriate level by considering
the following:
a. The manner in which the entity has prepared and supported its income tax
returns and considered whether such information is consistent with the selected
unit of account.
b. How the taxing authorities have historically challenged the tax position, if
applicable.
c. Whether the unit of account used for similar tax positions in both current and
prior periods is consistent.
(2) Read the appropriate authoritative tax literature to determine whether the uncertain
tax position meets the “more-likely-than-not” recognition threshold based solely on
the technical merits of the tax position.
a. If the entity obtains an opinion from outside tax advisors in the determination of
whether a tax position meets the “more-likely-than-not” recognition threshold:
i. Obtain copies or make abstracts of, all advice or opinions received by the
entity from outside tax.
ii. Audit the facts, assumptions, and conclusions in the advice or opinion
received by the entity from an outside tax advisor that is used by the entity
to support its accounting for income taxes.
iii. Consider whether involvement of Tax Specialists, including Washington
National Tax, or specific industry or subject matter experts is necessary.
(3) Determine that the amount of benefit recognized for the selected uncertain tax
position is the largest amount of tax benefit that is greater than 50 percent likely of
being realized upon ultimate settlement with a taxing authority that has full
knowledge of all relevant information by performing the following:
a. Read the entity’s documentation evidencing support of the amounts recorded in
the income statement. The entity’s documentation should provide information
about the amount recognized in the current-year income statement and the
amount that has been cumulatively recognized in the income statement.
b. Test management’s procedures and methods for developing their estimate of the

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largest amount of tax benefit that is greater than 50 percent likely of being
realized by performing the following:
i. The factors considered and assumptions made by management in
developing the estimate.
ii. The sources of data relevant to these factors and assumptions and the
procedures used to obtain the data.
c. Evaluate whether the factors considered and significant assumptions used in the
measurement analysis, taken individually and as a whole, provide a reasonable
basis for the amounts recorded for the unrecognized tax benefit.
B. Determine that uncertain tax positions for which the statute of limitations has expired have
been derecognized in the appropriate period.

Possible Procedure 2 — Test Valuation and Allocation and Accuracy of Interest


Expense for Uncertain Tax Positions Which Affect the Uncertain Tax Position
Liability and Income Tax Expense (Benefit) — Using Substantive Analytical
Procedures
A. Obtain from the entity a rollforward schedule of accrued interest of the amounts recorded
for unrecognized tax benefits for each relevant open tax year and tax jurisdiction and
perform the following:
(1) Determine that uncertain tax positions included in the accrued interest rollforward are
complete and that interest is accrued for each relevant tax position and by tax
jurisdiction.
(2) Test the mathematical accuracy of the schedule of the effect on accrued interest of the
amounts recorded for unrecognized tax benefits.
(3) Agree the balance of accrued interest recorded as of the end of the prior year to the
prior-year working papers, the amount of interest expense recorded for the current
year to the general ledger, and the amount of accrued interest recorded as of the end
of the current year to the general ledger.
B. Consider the following data to develop expectations of the current-year interest expenses:
(1) The prior-year balance
(2) Expected changes due to current-year activity
(3) Information obtained from prior-year tax returns.
C. Determine that the data used to develop our expectation is independent and reliable and
will provide a plausible and predictable relationship to the account balance being tested.
D. Determine the threshold for identifying differences between the expectations and the
recorded amount that is acceptable without further investigation.
E. Compare the expectations to the recorded amounts and identify any differences. For any
difference that is more than the threshold, obtain, quantify, and corroborate explanations for
the difference by performing further analysis or inquiry and examining supporting

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documents.

Possible Procedure 3 — Test Valuation and Allocation and Accuracy of Interest


Expense for Uncertain Tax Positions Which Affect the Uncertain Tax Position
Liability and Income Tax Expense (Benefit) — Using Tests of Details
A. Obtain from the entity a rollforward schedule of accrued interest of the amounts recorded
for unrecognized tax benefits for each relevant open tax year and tax jurisdiction and
perform the following:
(1) Determine that uncertain tax positions included in the accrued interest rollforward are
complete and that interest is accrued for each relevant tax position and by tax
jurisdiction.
(2) Test the mathematical accuracy of the schedule of the effect on accrued interest of the
amounts recorded for unrecognized tax benefits.
(3) Agree the balance of accrued interest recorded as of the end of the prior year to the
prior-year working papers, the amount of interest expense recorded for the current
year to the general ledger, and the amount of accrued interest recorded as of the end
of the current year to the general ledger.
B. Make an audit sample of the interest expense recorded for specific uncertain tax positions
and perform the following:
(1) Determine whether the interest rate applied to uncertain tax positions is appropriate.
(2) Recalculate interest expense recorded for the uncertain tax position.

ACCOUNT BALANCE ASSERTION — COMPLETENESS AND ACCURACY OF


INCOME TAX EXPENSE (BENEFIT) AND COMPLETENESS AND VALUATION AND
ALLOCATION OF UNCERTAIN TAX POSITIONS

Possible Procedure 1 — Test Completeness and Accuracy of Tax Adjustments


Related to Tax Audits on Income Tax Expense (Benefit) and Completeness and
Valuation and Allocation of Tax Adjustments Related to Tax Audits on Uncertain
Tax Positions
A. Inquire of management as to any notifications received from taxing authorities as to any
pending tax examinations.
B. Inquire as to the status of any current tax examinations and evaluate whether any matters
have been identified that could indicate the need for an uncertain tax position or whether
the valuation of uncertain tax position(s) is appropriate.
C. Obtain any reports and related audit adjustments issued by taxing authorities as a result of
completed examinations and determine whether the amounts reflected in the financial
statements are appropriate.

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EQUITY
Note: This guide does not include possible procedures to test risks of material misstatement at
the assertion level for stock-based compensation expense and the related amounts recorded in
equity. Users should refer to the Stock-Based Compensation Substantive Procedures Guide
included below.
ACCOUNT BALANCE ASSERTION — EXISTENCE OF EQUITY

Possible Procedure 1 — Test Equity Account Balances


A. Obtain a schedule of changes in all equity accounts and all transactions affecting equity
(e.g., dividends, retained earnings, capital stock donated to the enterprise, and other
amounts within accumulated other comprehensive income, such as foreign currency
translation adjustments) occurring during the year.
B. Agree the beginning balances of the schedule of changes in equity to prior-year working
papers and agree the ending balances to the general ledger. Trace significant reconciling
items, if any, to supporting documents.
(1) Consider using ACL (or another method if more efficient) to test the summarization
of the schedule.
(2) Test the summarization and the reconciliation of the total to the general ledger.
(3) Agree changes in authorized shares to minutes and documents filed with the state of
incorporation.
(4) Examine changes in capital.
a. Trace to appropriate authorizations (e.g., approval documented in minutes of
meetings of those charged with governance).
b. Agree number of shares and proceeds from issuance of new shares to cash
receipts and supporting records.
c. Agree number of shares and value of redemptions to cash disbursements and
supporting records.
(5) Prepare, or have the entity prepare, confirmation requests to the transfer agent to
verify outstanding shares at period end. Mail the confirmation requests under our
control and request that all confirmation replies be sent directly to us. If there is no
transfer agent, agree the shares to the stock register.
C. Make an audit sample of entries to paid-in-capital to test those entries other than from the
issuance of securities.
(1) Verify that capital surplus, however created, was not used to relieve income of the
current or future years of charges that would otherwise be made against income. If
capital surplus was used to relieve income of the current or future years of charges
that would otherwise be made against income, inquire and document your inquiries as
to why this has occurred.

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Possible Procedure 2 — Confirm Stock Issued


A. Make an audit sample of issued stock from the registrar and transfer agent. For each
selection, perform the following:
(1) Prepare, or have the entity prepare, confirmation requests of the issued stock. Mail
the confirmation requests under our control, determine that the requests are properly
addressed (i.e., obtain audit evidence about the accuracy and completeness of
addresses provided by the entity), and request that all replies be sent directly to our
office.
(2) Send second requests for nonreplies.
(3) Compare replies to requests. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.

Possible Procedure 3 — Treasury Stock


A. If the entity holds treasury stock, obtain and document your understanding regarding the
manner in which the entity accounts for gains, losses, dividends, retirements, purchases,
purchase for purposes other than retirement, and state laws governing treasury stock
transactions.
(1) Prepare, or have the entity prepare, confirmation requests of outstanding treasury
stock. Mail the confirmation requests under our control, determine that the requests
are properly addressed (i.e., obtain audit evidence about the accuracy and
completeness of addresses provided by the entity), and request that all replies be sent
directly to our office.
(2) Send second requests for nonreplies.
(3) Compare replies to requests. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.
(4) Trace nonreplies to subsequent cash receipts and /or other supporting documentation
of the transaction.
ACCOUNT BALANCE ASSERTION — RIGHTS AND OBLIGATIONS OF EQUITY

Possible Procedure 1 — Confirm Stock Issued and Outstanding and Treasury


Stock
A. Prepare, or have the entity prepare, confirmation requests of stock issued and outstanding.
Mail the confirmation requests under our control, determine that the requests are properly
addressed (i.e., obtain audit evidence about the accuracy and completeness of addresses
provided by the entity), and request that all replies be sent directly to our office.
B. Send second requests for nonreplies.
C. Compare replies to requests. Prepare, or have the entity prepare, reconciliations of
exceptions. Trace reconciling items to supporting documents.
D. Trace nonreplies to subsequent cash receipts.

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Possible Procedure 2 — Test Dividends Declared or Distributed


A. Determine that dividends declared or distributed have been correctly recorded.
(1) Review extracts of minutes of meetings of those charged with governance for
dividends declared or distributed.
B. Agree changes in retained earnings (e.g., income, dividends) to supporting documentation
and trace ending balance to general ledger and equity accounts.
ACCOUNT BALANCE ASSERTION — EXISTENCE AND COMPLETENESS OF
EQUITY

Possible Procedure 1 — Test Dividends Declared or Distributed


A. Determine that dividends declared or distributed have been correctly recorded.
(1) Review extracts of minutes of meetings of those charged with governance for
dividends declared or distributed.
B. Agree changes in retained earnings (e.g., income, dividends) to supporting documentation
and trace ending balance to general ledger and equity accounts.
ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION OF
EQUITY

Possible Procedure 1 — Test Retained Earnings


A. Agree changes in retained earnings (e.g., income, dividends) to supporting documentation
and trace ending balance to general ledger and equity accounts.

Possible Procedure 2 — Test Dividends Declared or Distributed


A. Use ACL (or another method if more efficient) to recompute calculation of dividends and
trace total dividends to earnings statement.
B. Use ACL (or another method if more efficient) to recompute the liability for dividends.
C. Verify that the entity has treated the dividends on treasury stock as a debit to equity.

Possible Procedure 3 — Test Treasury Stock


A. Verify that gains or losses on treasury stock transactions are accounted for as capital
transactions and not as income transactions.
(1) Verify that any gains on sales of treasury stock not previously accounted for as
constructively retired have been credited to additional paid-in capital.
(2) Verify any losses incurred have been charged to additional paid-in capital to the
extent that previous net “gains” from sales or retirements of the same class of stock
are included therein or otherwise charged to retained earnings.
(3) Obtain and test documentation related to any gains or losses on treasury stock
transactions.

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B. If treasury stock has been retired or purchased for constructive retirement (with or without
an intention to retire the stock formally in accordance with applicable laws), verify that the
following accounting has been applied:
(1) Any excess of purchase price over par or stated value was either appropriately
allocated between capital surplus and retained earnings or charged entirely to retained
earnings.
(2) Any excess of par or stated value over purchase price was credited to capital surplus.
C. If treasury stock is acquired for purposes other than retirement (formal or constructive) or if
ultimate disposition has not yet been decided, determine the cost of treasury stock
accounted for is either:
(1) Shown as a deduction from the total of capital stock, capital surplus, and retained
earnings.
(2) Accorded the accounting treatment appropriate for retired stock.
D. If treasury stock has been acquired at a price significantly in excess of the current market
price of the shares by the entity, verify that:
(1) A determination has been made whether the purchase price includes amounts
attributable to stated or unstated rights, privileges, or agreements in addition to the
capital stock.
(2) If the purchase price includes amounts attributable to elements other than the capital
stock, that (a) amounts attributable to those elements have been accounted for
according to their substance, and (b) amounts attributable to the fair value of the
treasury shares (measured at the date the major terms of the agreement to purchase
the shares are reached) have been accounted for at the cost of those shares.
E. If no elements in addition to the capital stock have been identified, verify that the entire
purchase price has been accounted for at the cost of the treasury shares by obtaining and
testing documentation (e.g., schedules prepared by management, support for the price of
the treasury stock, purchase agreement, support for current market price of shares)
supporting the transaction.

Possible Procedure 4 — Test Stock Dividends and Stock Splits


A. If the entity had any stock dividends and stock splits involving issuance by the entity (if
other than a closely held entity) of additional shares in ratios of less than 20 to 25 percent
of the previously outstanding shares, verify that the transaction was accounted for by
transferring from retained earnings to the category of permanent capitalization (represented
by the capital stock and capital surplus accounts) at an amount equal to the fair value of the
additional shares issued.
(1) Obtain and test the documentation (e.g., agreements, board of director minutes, fair
value schedules of the additional shares, schedules prepared by the entity
documenting the accounting for the transaction) supporting the transaction.
B. If a subsidiary of the entity has capitalized retained earnings arising since acquisition, by
means of a stock dividend or otherwise, verify that the retained earnings in the consolidated

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financial statements reflect the accumulated earnings of the consolidated group not
distributed to the shareholders of, or capitalized by, the parent entity.
(1) Obtain and test the documentation (e.g., stock dividend agreements, board of director
minutes, schedules prepared by the entity documenting the accounting for the
transaction) supporting the transaction.

Possible Procedure 5 — Test Recording of Accumulated Other Comprehensive


Income
A. Obtain a listing of entries, made in the current period, to accumulated other comprehensive
income.
B. Agree the beginning balances to prior-year working papers and agree the ending balances
to the general ledger.
C. Make an audit sample of the entries to accumulated other comprehensive income.

Possible Procedure 6 — Test Preferred Stock Outstanding That Provides for


Redemption
A. If the entity’s redeemable preferred stock outstanding has a redemption that is not solely
within the control of the entity, is currently redeemable, or is probable that the preferred
stock will become redeemable and the entity is an SEC registrant or has elected to follow
accounting policies for public companies, perform the following:
(1) If the preferred stock is currently redeemable, verify the preferred stock was adjusted
to its redemption amount at each balance sheet date.
(2) If the redeemable preferred stock is not redeemable currently but it is probable that it
will become redeemable, verify the stock’s carrying amount is either (a) accreted to
its redemption amount by making periodic charges (calculated over the period to the
earliest redemption date of the preferred stock) to retained earnings (or in the absence
of retained earnings, to additional paid in capital) using the interest method, or (b)
adjusted at the end of each reporting period to an amount equal to the redemption
value with changes in the redemption value recognized immediately as they occur.
[Note: The accretion should be deducted from net income in determining earnings
applicable to common stock.]
(3) Determine that the carrying amount of the redeemable preferred stock has been
periodically increased by amounts representing dividends not currently declared or
paid but that will be payable under the mandatory redemption features, or for which
ultimate payment is not solely within the control of the registrant (e.g., dividends that
will be payable out of future earnings).
B. If the entity has mandatorily redeemable stock outstanding and the redemption is certain to
occur and is not conditional, verify that the preferred stock is classified as a liability rather
than within equity UNLESS the redemption is required to occur only upon the liquidation
or termination of the reporting entity.

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Possible Procedure 7 — Test Preferred Stock Outstanding with a Nondetachable


Conversion Feature and/or Other Detachable Instruments
A. For the convertible preferred securities that have been issued with a nondetachable
conversion feature and/or other detachable instruments, verify the following:
(1) The entity has evaluated whether the conversion feature should be bifurcated in
accordance with ASC 815, Derivatives and Hedging.
(2) If the conversion feature is not required to be bifurcated in accordance with ASC 815,
verify the entity has allocated the proceeds received to the convertible instrument and
any other detachable instruments (e.g., warrants) on a relative fair value basis.
(3) If the conversion feature is not required to be bifurcated in accordance with ASC 815,
verify the entity has determined whether the conversion feature is in-the-money at the
date of issue (a “beneficial conversion feature”). If the conversion feature has been
determined to be a beneficial conversion feature:
a. Obtain management’s calculation for such transactions and verify whether the
effective conversion price, based on the proceeds received for or allocated to the
convertible instrument, has been used to compute the intrinsic value, if any, of
the embedded conversion feature.
b. Verify the portion that is allocated to the beneficial conversion feature is
accounted for as paid-in capital.
c. Verify that any discounts resulting from an allocation of the proceeds for
convertible instruments that do not have a stated redemption date, such as
perpetual preferred stock, to the beneficial conversion feature were reflected as
a return to the preferred shareholders over the minimum period from the date of
issuance to the date at which the preferred shareholders can realize that return
(i.e., through the date of earliest conversion) using the interest method.
d. Obtain and test the calculation supporting recognition of the return to the
preferred shareholders over the minimum period from the date of issuance to the
date at which the preferred shareholders can realize that return (i.e., through the
date of earliest conversion) using the interest method for convertible
instruments that do not have a stated redemption.
e. For convertible instruments that have a stated redemption date (e.g.,
mandatorily redeemable preferred stock), verify the discount resulting from
recording a beneficial conversion option has been accreted from the date of
issuance to the stated redemption date, regardless of when the earliest
conversion date occurs.
f. If the conversion feature incorporates a multiple step discount, verify that the
intrinsic value was determined using terms that are most beneficial to the
investor and that the amortization is adjusted so that the discount at any time is
not less than the amount the holder could obtain if conversion occurred at that
date.

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SALES

ACCOUNT BALANCE ASSERTION — OCCURRENCE OF SALES6

Possible Procedure 1 — Perform Substantive Analytical Procedures on Sales


Transactions for the Current Period
A. Perform substantive analytical procedures to test the recorded sales balance by performing
the following:
(1) Develop an expectation of the sales amount for the current period using appropriate
data.
(2) Disaggregate both the data used to build the expectations and the various recorded
sales amounts at a level of detail sufficient to enable us to identify material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount

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of the difference, not just for the part that exceeds the threshold.

Possible Procedure 2 — Perform Tests of Details on Sales Transactions


A. Make an audit sample of recorded sales transactions. For each selection, perform the
following:
(1) Trace the item to a sales invoice and final sales contract or purchase order (if
applicable).
(2) Review shipping records or evidence of service performance.
(3) Trace the sales invoice amount to a sales journal.
(4) Trace the sales journal total to the general ledger.

Possible Procedure 3 — Determine Whether There Are Any Significant Revenue


Streams Included in Recorded Revenues That Lack Appropriate Economic
Substance
A. Make inquiries of the entity’s sales, marketing, and other operations personnel regarding
sales, inventory shipments or adjustments during the period and their knowledge of any
unusual terms or conditions associated with these transactions.
B. Test whether it was appropriate to recognize revenue for the following revenue streams by
examining the sales contract/purchase order, other communications, etc:
(1) Consignment sales
(2) Sales with recourse
(3) Bill and hold sales
(4) Bulk sales orders with multiple shipping dates
(5) Deferred revenues
(6) Installment sales
(7) Initiation or membership fees
(8) Nonrefundable fees.

Possible Procedure 4 — Determine Whether Any Significant Revenue Streams


Are Included in Recorded Revenue That Are Not Converted to Cash in a
Relatively Short Period of Time
A. Make inquiries of the entity’s sales, marketing, and other operations personnel regarding
sales, inventory shipments, or adjustments during the period and their knowledge of any
unusual terms or conditions associated with these transactions.
B. Examine the accounts receivables aging and inquire as to the nature of any significantly
aged receivables (>60 days).
C. Read significant sales agreements signed in the current period.
D. Consider the following in relation to any significant revenue streams which will not be

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converted to cash in a relatively short period of time identified above:


(1) The nature of the specific transactions
(2) Who bears the risk in the transactions
(3) Payment terms
(4) The nature of any related contingencies.

Possible Procedure 5 — Perform Tests of Details on Sales Returns


A. Make an audit sample from recorded sales returns and trace back to supporting
documentation (e.g., receiving document, credit note and original sales invoice).

Possible Procedure 6 — Using Analytical Procedures and/or Tests of Details to


Update Occurrence Tests Performed at an Interim Date
A. Make inquiries of the entity’s sales, marketing, and other operations personnel regarding
sales, inventory shipments, or adjustments during the intervening period and their
knowledge of any unusual terms or conditions associated with these transactions.
(1) Determine if the appropriate revenue recognition was applied based on the findings.
B. Perform substantive analytical procedures to test the account balance change in the
intervening period (i.e., from the interim test date to the year-end balance sheet date).
(1) Develop expectations of the account balance change in the intervening period
considering factors identified during the interim test as well as those identified during
inquires made.
(2) Determine threshold.
(3) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.
And/or
C. Perform test of details on account balance change in the intervening period (i.e., from the
interim test date to the balance sheet date) and trace to supporting documentation.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF SALES

Possible Procedure 1 — Perform Test of Details on Population Independent of


Recorded Sales
A. Make an audit sample of either debits to cost of sales or items from other independent
source records corresponding to revenue transactions (e.g., shipping records). [Note:
calculate audit sample size based on sales balance, not total debits to costs of sales.] For
each selection, perform the following:
(1) Trace the item to a sales invoice and final sales contract or purchase order (if

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applicable).
(2) Trace the sales invoice amount to a sales journal and general ledger.

Possible Procedure 2 — Perform Substantive Analytical Procedures on Sales


Transactions for the Current Period
A. Perform substantive analytical procedures to test the recorded sales balance by performing
the following:
(1) Develop an expectation of the sales amount for the current period using appropriate
data.
(2) Disaggregate both the data used to build the expectations and the various recorded
sales amounts at a level of detail sufficient to enable us to identify material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

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ACCOUNT BALANCE ASSERTION — ACCURACY OF SALES

Possible Procedure 1 — Perform Test of Details on the Accuracy of Sales


Transactions
A. For the selections made to test Occurrence of sales transactions (Possible Procedure 2 —
for the Occurrence Assertion above) or Completeness of recorded sales balance (Possible
Procedure 1 — for the Completeness Assertion above), perform the following:
(1) Agree the sales invoice prices to a price list.
(2) Verify additions and extensions on the invoice.

Possible Procedure 2 — Perform Substantive Analytical Procedures on Sales


Transactions for the Current Period
A. Perform substantive analytical procedures to test the recorded sales balance by performing
the following:
(1) Develop an expectation of the sales amount for the current period using appropriate
data.
(2) Disaggregate both the data used to build the expectations and the various recorded
sales amounts at a level of detail sufficient to enable us to identify material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the

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information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

Possible Procedure 3 — Perform Test of Details on Adjustments to Sales


Transactions
A. Make a selection of debits (e.g., credit memos or adjustments) to sales during the period
and perform the following:
(1) For selections representing adjustments to sales, examine the journal entry supporting
the adjustment and determine the appropriateness of the adjustment. Consider
whether such adjustments represent corrections of data entry errors, pricing, or
discounts.
(2) For selections representing credit memos, obtain credit memos supporting debits to
sales transaction and examine original invoices, shipping documents, return logs and
customer correspondence and recalculate the debit.

ACCOUNT BALANCE ASSERTION — CUTOFF OF SALES

Possible Procedure 1 — Sales Cutoff Considerations


A. For the selections made to test occurrence of sales transactions (Possible Procedure 2 — for
the Occurrence Assertion above), perform the following:
(1) Review shipping records or evidence of service performance to determine that the
sale was recorded in the correct period, based on terms of the sales agreement.

Possible Procedure 2 — Perform Substantive Analytical Procedures on Sales


Transactions for the Current Period
A. Perform substantive analytical procedures to test the recorded sales balance by performing
the following:
(1) Develop an expectation of the sales amount for the current period using appropriate
data.
(2) Disaggregate both the data used to build the expectations and the various recorded
sales amounts at a level of detail sufficient to enable us to identify material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.

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b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

Possible Procedure 3 — Sales Cutoff Considerations


A. Make an audit sample of original shipping documents or invoices for services performed in
the [x]-day period prior to year-end. Document the rationale for days selected. For each
selection, perform the following:
(1) Trace the selected shipping documents or invoices to proof to title transfer or
evidence of service performance.
(2) Determine that the sales were recorded in the correct period. Consider the following:
a. Whether delivery has occurred or services have been rendered prior to period-
end. Delivery generally is not considered to have occurred unless the customer
has taken title and assumed the risks and rewards of ownership of the products
specified in the customer’s purchase order or sales agreement. After delivery of
a product or performance of a service, if uncertainty exists about customer
acceptance, revenue should not be recognized until acceptance occurs.
B. Make an audit sample of shipping documents or sales invoices for services provided
recorded in the [x]-day period after year-end. Document rationale for days selected. For
each selection, perform the following:

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(1) Examine the shipping records or evidence of service performed.


(2) Determine that the sales were recorded in the correct period. Consider the following:
a. Whether delivery had occurred or services had been rendered prior to period-
end. Delivery generally is not considered to have occurred unless the customer
has taken title and assumed the risks and rewards of ownership of the products
specified in the customer’s purchase order or sales agreement. After delivery of
a product or performance of a service, if uncertainty exists about customer
acceptance, revenue should not be recognized until acceptance occurs.

Possible Procedure 4 — Cutoff Considerations Related to Credit Notes


A. Make an audit sample of credit notes recorded in the [x]-day periods after and prior to year-
end. Document rationale for days selected. For each selection, perform the following:
(1) Trace the credit memos to receiving records or other appropriate documentation and
determine that they were recorded as debits to sales in the correct period. Consider
using ACL to perform these procedures.
(2) If supporting documentation cannot be located and no other acceptable alternative
evidence can be found:
a. Consider the selected items to have misstatements equal to the book value of the
unsupported amounts
b. Consider whether the reason for our inability to examine supporting
documentation has implications related to assessing risks of material
misstatement due to fraud, our planned level of control assurance or our degree
of reliance on management’s representations.

ACCOUNT BALANCE ASSERTION — CLASSIFICATION OF SALES

Possible Procedure 1 — Testing Entity’s Compliance with Accounting Policies


(Gross vs. Net) and GAAP
A. Determine whether the entity is appropriately under GAAP and consistently with their
accounting policies accounting for certain transactions net versus gross, such as, but limited
to: shipping and handling costs, sales tax and agent versus principle arrangements.
(1) Read the accounting policies of the entity and inquire of appropriate accounting
personal as to the treatment of certain transactions which may be accounted for under
GAAP as gross or net, based on facts and circumstances. Determine whether the
entity’s accounting policies appear to be consistent with GAAP.
(2) Test that entity’s accounting policies are applied consistently by performing one of
the following:
a. Test classification of sales for all audit samples made during the testing of other
relevant sales assertions above, or
b. Incorporate appropriate factors into substantive analytical procedures to test
classification of sales.

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Possible Procedure 2 — Determine That Sales Are Properly Classified


A. Understand the impact of significant accounting policies and compliance with applicable
accounting pronouncements on sales balances.

[Note: Significant activity has occurred in recent years relating to EITF and SEC
interpretations of the authoritative accounting literature relating to revenue recognition.
Companies should determine that they are in compliance with the EITF issues related to
revenue recognition. Companies registered with the SEC or that are contemplating registering
with the SEC should comply with the provisions of Staff Accounting Bulletin (SAB) Topic 13.
Additionally, private companies should comply with SAB 104 [ASC 605, Revenue
Recognition] unless there is a more appropriate revenue recognition model to apply.]
B. Determine that the accounting policies and methods for revenue recognition are appropriate
and are applied consistently. Consider performing one of the following:
(1) If tests of details are performed to test sales, test classification of sales selected for
testing, or
(2) Incorporate appropriate factors into substantive analytical procedures to test
classification of sales.

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COST OF SALES

ACCOUNT BALANCE ASSERTION — OCCURRENCE OF COST OF SALES

Possible Procedure 1 — Perform Substantive Analytical Procedures on the Cost


of Sales Balance for the Current Period
A. Perform substantive analytical procedures to test the cost of sales balance by performing
the following:
(1) Develop an expectation of the cost of sales amount for the current period using
appropriate data, such as: audited sales amounts; historical and current-year trends in
gross margins; sales and margins on sales to largest customers; information about
units and costs prepared independently of the accounting department; changes in the
business, such as in sales mix and pricing; industry statistics obtained from an
external source.
(2) Disaggregate both the data used to build the expectations and the various recorded
cost of sales amounts at a level of detail sufficient to enable us to obtain material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.

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(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

Possible Procedure 2 — Perform Tests of Details on Cost of Sales Transactions


A. Reconcile recorded cost of sales to corresponding credits in inventory accounts (i.e., relief
of inventory, book to physical, and LIFO adjustments, if applicable).
B. Make an audit sample of debits to cost of sales accounts recorded in the general ledger. For
each selection perform the following:
(1) Trace the selected debits to cost of sales journals (which may also be sales journals).
(2) Trace the item to a sales invoice and shipping record.

Possible Procedure 3 — Using Analytical Procedures and/or Tests of Details to


Update Occurrence Tests Performed at an Interim Date
A. Make inquiries of the entity’s sales and operations personnel regarding sales, inventory
shipments or adjustments during the intervening period and their knowledge of any unusual
terms or conditions associated with these transactions.
B. Perform substantive analytical procedures to test the account balance change in the
intervening period (i.e., from the interim test date to the balance sheet date).
(1) Develop expectations of the account balance change in the intervening period
considering factors identified during the interim test as well as those identified during
inquires made.
(2) Determine threshold.
(3) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.
And/or
C. Perform test of details on account balance change in the intervening period (i.e., from the
interim test date to the balance sheet date) and trace to supporting documentation.

ACCOUNT BALANCE ASSERTION — COMPLETENESS OF COST OF SALES

Possible Procedure 1 — Performing Gross Margin Analysis


A. Obtain product and service revenue and related cost of goods sold data for the period and
for a reasonable historical period.
B. Disaggregate the data as necessary to form a reasonable conclusion. Consider the
following:

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(1) Diversity of economic conditions impacting products or product lines


(2) Diversity of margins between products or product lines
(3) Known changes in raw materials, labor, and/or overhead
(4) Historical and current period product mix.
C. Compare current period with historical trends and conclude as to whether costs of sales
appear to be materially understated.

Possible Procedure 2 — Perform Substantive Analytical Procedures on the Cost


of Sales Balance for the Current Period
A. Perform substantive analytical procedures to test the cost of sales balance by performing
the following:
(1) Develop an expectation of the cost of sales amount for the current period using
appropriate data, such as: audited sales amounts; historical and current-year trends in
gross margins; sales and margins on sales to largest customers; information about
units and costs prepared independently of the accounting department; changes in the
business, such as in sales mix and pricing; industry statistics obtained from an
external source.
(2) Disaggregate both the data used to build the expectations and the various recorded
cost of sales amounts at a level of detail sufficient to enable us to obtain material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the

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entity’s underlying data or third-party source documents into the


information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

ACCOUNT BALANCE ASSERTION — ACCURACY OF COST OF SALES

Possible Procedure 1 — Perform Tests of Details on the Accuracy of Cost of


Sales Transactions
A. For the selections made to test occurrence of cost of sales transactions (Possible Procedure
2 — for the occurrence assertion above), perform the following:
(1) If the item was initially purchased or acquired in the prior year, trace the cost to the
prior year inventory compilation and examine supporting documents to verify any
added costs in the current year.
(2) If the item was produced or acquired in the current year, examine supplier invoices
and documents supporting added costs.
(3) Verify the accuracy of the supporting cost records.
(4) Agree the cost to the corresponding credit to inventory.

Possible Procedure 2 — Perform Substantive Analytical Procedures on the Cost


of Sales Balance for the Current Period
A. Perform substantive analytical procedures to test the cost of sales balance by performing
the following:
(1) Develop an expectation of the cost of sales amount for the current period using
appropriate data, such as: audited sales amounts; historical and current-year trends in
gross margins; sales and margins on sales to largest customers; information about
units and costs prepared independently of the accounting department; changes in the
business, such as in sales mix and pricing; industry statistics obtained from an
external source.
(2) Disaggregate both the data used to build the expectations and the various recorded
cost of sales amounts at a level of detail sufficient to enable us to obtain material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.

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b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

ACCOUNT BALANCE ASSERTION — CUTOFF OF COST OF SALES

Possible Procedure 1 — Perform Tests of Details on Cost of Sales Transactions


A. For the selections made to test occurrence of cost of sales transactions (Possible Procedure
2 — for the occurrence assertion above), determine that the debits to cost of sales were
recorded in the appropriate period.
B. Make an audit sample of recorded cost of sales in the [x]-day period subsequent to year-
end. Document the rationale for days selected. For each selection, perform the following:
(1) Trace the selected expenses to invoices, receiving reports, purchase orders, or other
support evidencing when goods were received or services were rendered.
(2) Determine that the expenses were recorded in the correct period by tracing the
selection to the general ledger.

Possible Procedure 2 — Perform Substantive Analytical Procedures on the Cost


of Sales Balance for the Current Period
A. Perform substantive analytical procedures to test the cost of sales balance by performing

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the following:
(1) Develop an expectation of the cost of sales amount for the current period using
appropriate data, such as: audited sales amounts; historical and current year trends in
gross margins; sales and margins on sales to largest customers; information about
units and costs prepared independently of the accounting department; changes in the
business, such as in sales mix and pricing; industry statistics obtained from an
external source.
(2) Disaggregate both the data used to build the expectations and the various recorded
cost of sales amounts at a level of detail sufficient to enable us to obtain material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

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ACCOUNT BALANCE ASSERTION — CLASSIFICATION OF COST OF SALES

Possible Procedure 1 — Examining Cost of Sales Items That Do Not Result from
a Credit to Inventory or Allocation of Overhead
A. Using ACL (or other method if more effective), filter all debits to cost of goods sold that
did not result from a credit to inventory or allocation of overhead and perform the
following:
(1) Make an audit sample and obtain the invoice or other supporting documentation.
(2) Determine whether expense represents a product cost.

Possible Procedure 2 — Perform Substantive Analytical Procedures on the Cost


of Sales Balance for the Current Period
A. Perform substantive analytical procedures to test the cost of sales balance by performing
the following:
(1) Develop an expectation of the cost of sales amount for the current period using
appropriate data, such as: audited sales amounts; historical and current-year trends in
gross margins; sales and margins on sales to largest customers; information about
units and costs prepared independently of the accounting department; changes in the
business, such as in sales mix and pricing; industry statistics obtained from an
external source.
(2) Disaggregate both the data used to build the expectations and the various recorded
cost of sales amounts at a level of detail sufficient to enable us to obtain material
misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and

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file-interrogation software on computer-generated information.


(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

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STOCK-BASED COMPENSATION EXPENSE/ACCRUAL


Note: This guide includes possible procedures to address risks of material misstatement at
the assertion level for stock based compensation expense and the corresponding balance
sheet accounts (e.g., liability, additional paid-in capital).

ACCOUNT BALANCE ASSERTIONS — INCOME STATEMENT — OCCURRENCE,


COMPLETENESS, AND CUTOFF

BALANCE SHEET — EXISTENCE, RIGHTS & OBLIGATIONS, AND


COMPETENESS

Possible Procedure 1 — Test the Number of Stock Options or Equity


Instruments Outstanding at Year-End and the Activity During the Year
A. Obtain a rollforward schedule (or schedules) of activity for all share-based awards, starting
with the beginning balance and showing all activity throughout the year.
(1) Verify the schedule (or schedules) includes the number and exercise prices of options,
including nonvested shares, for each of the following groups:
a. Options outstanding at the beginning of the year
b. Options granted during the year
c. Options exercised during the year
d. Options forfeited during the year
e. Options cancelled during the year
f. Options expired during the year
g. Options outstanding at the end of the year
h. Options exercisable at the end of the year.
(2) For each option granted, verify that the schedule identifies the grant-date fair value,
the amount of the related compensation expense recorded, and the total compensation
expense reconciled to the general ledger.
B. Obtain detailed rollforward schedules or analyses, as applicable, which illustrate the share-
based awards activity in shareholders’ equity, liabilities, and temporary equity [pursuant to
SEC Staff Accounting Bulletin Topic 14.E, “Statement 123R and Certain Redeemable
Financial Instruments” (SAB 107)].
(1) Verify that the schedules have the following captions:
a. Beginning-of-year balance
b. Awards granted during the year
c. Awards cancelled during the year
d. Awards expired during the year

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e. Awards forfeited during the year


f. Awards vesting during the year (i.e., amortization of compensation expense)
g. Adjustments for mark-to-market accounting
h. Balance at end of year, which reconciles to the amounts in the financial
statements.
(2) Determine that the schedule reconciles to the total compensation expense recorded in
the general ledger.
C. Test the mathematical accuracy of the schedules.
D. Reconcile the totals from the schedules to the general ledger, and test any reconciling
items.
E. Agree relevant information from the schedules to the financial statements, including the
relevant footnote disclosures.
F. Test stock options (including nonvested share awards) outstanding at the beginning of the
period by performing the following:
(1) Agree the number of stock options outstanding at the beginning of the year per the
detailed listing of stock options to prior-year working papers.
(2) Make an audit sample of stock options from the beginning balance of stock options
from the schedule obtained in Procedures A and B, based on the total of the
unamortized fair value of those options at the beginning of the year. Note that each
selection should represent awards for a single individual that were issued at a single
grant date.
a. For each selection, determine that the option is still outstanding by obtaining
appropriate evidence supporting that the employee is still working for the entity
and that the option has not been cancelled or forfeited.
b. For each selection, determine that the terms of the option have not changed
during the period. Consider confirming the terms directly with the employee
and/or someone responsible for monitoring stock option activity at the entity.
c. If the selected option is exercisable at the end of the year, agree the option to the
listing of options exercisable at the end of the year.
G. Test options granted in the current year (including nonvested share awards) by making an
audit sample from the schedule obtained in Procedures A and B, based on the original fair
value amounts, of the options granted in the current year (including nonvested share
awards) and perform the procedures below. Each selection should represent awards for a
single individual that were issued at a single grant date.
(1) Determine that the options were granted in the current year, and that they still remain
outstanding, by agreeing those options and the terms accompanying the options
activity listing to appropriate supporting documentation, including plan documents,
board of directors’ or other appropriate committee (e.g., compensation committee)
minutes, or other appropriate authorizations.
(2) For each selection, determine that the appropriate grant date (i.e., the date at which an

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employer and an employee reach a mutual understanding of the key terms and
conditions of a share-based payment award) is used. Obtain adequate evidence to
support the grant date and exercise price, and that all of the prerequisites to a grant
had occurred (including verifying that the grant date is consistent with the
communication date of the award to the employee and that the communication occurs
within a “relatively short period of time” as defined by the entity).
H. Test options exercised by making an audit sample from the schedule obtained in
Procedures A and B of options exercised, based on the fair value of options that were
exercised, and agree to appropriate documentation (e.g., letter from employee, terms of the
plan instrument) supporting the exercise.
(1) For each selection, determine that the award was exercised based on the terms of the
award agreement (e.g., exercise price was paid, stock certificates were issued, and
awards were exercisable).
I. Test options exercisable at the end of the year by making a selection of options exercisable
at the end of the year from the schedules obtained in Procedures A and B, and performing
the following:
(1) Determine that the option is exercisable by obtaining appropriate evidence that the
employee is still working for the entity and comparing the terms of the option per the
option activity listing to the plan instrument and determine that all vesting conditions
were met.
(2) Confirm that the option has not been previously expired, cancelled, exercised, or
forfeited by confirming directly with the employee and/or someone responsible for
monitoring stock option activity at the entity.
ACCOUNT BALANCE ASSERTION — INCOME STATEMENT — COMPLETENESS
AND ACCURACY

BALANCE SHEET — COMPLETENESS AND VALUATION AND ALLOCATION

Possible Procedure 1 — Test Forfeited, Cancelled, or Expired Options


A. Test options forfeited, cancelled, or expired by making an audit sample from the schedule
obtained in Steps A and B of Possible Procedure 1 for testing of the Existence, Rights &
Obligations, and Completeness assertions from a balance sheet perspective and testing of
the Occurrence, Completeness, and Cutoff assertions from an income statement
perspective. Make an audit sample of options forfeited, cancelled, or expired, based on the
remaining fair value of options that were forfeited, cancelled, or expired, and agree to
appropriate documentation (e.g., letter from employee, terms of the plan instrument)
supporting the forfeiture, cancellation, or expiration.
(1) For each selection, recalculate the amount of the unrecognized fair value based on the
original fair value amount, and determine that the remaining amounts are correct and
that they have been appropriately removed from the schedule. Determine that the
remaining compensation expense related to awards that were cancelled or expired is
recognized and that previously recognized compensation expense is not reversed.
Determine that the compensation expense was not recognized for awards that were

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forfeited because a service or performance condition has not been satisfied.


ACCOUNT BALANCE ASSERTION — VALUATION AND ALLOCATION

Possible Procedure 1 — Test Stock-Based Awards for Proper Allocation


A. For each selection made in Steps A and B for Possible Procedure 1 to test the Existence,
Rights & Obligations, and Completeness assertions from a balance sheet perspective and
testing of the Occurrence, Completeness, and Cutoff assertions from an income statement
perspective, read the award documents, including the stock option plan, to determine
whether the award is properly classified (i.e., credit is to shareholders’ equity, liabilities, or
temporary equity).
ACCOUNT BALANCE ASSERTION — INCOME STATEMENT — ACCURACY

BALANCE SHEET — VALUATION AND ALLOCATION

Possible Procedure 1 — Test the Fair Value of Stock-Based Awards Granted in


the Current Period
A. For each of the awards that were granted in the current period and selected to test the
Existence assertion, obtain and read the analysis supporting the fair value of each selected
award, including schedules and narrative.
B. Assess whether the methodology/valuation technique is appropriate in the circumstances
for the share-based compensation that is being fair valued and whether the method (or
methods) used for determining fair value is applied consistently with the preceding periods
(given possible changes in the environment or circumstances affecting the entity or changes
in accounting principles).
(1) Consider the following, as applicable:
a. Whether management has sufficiently evaluated and appropriately applied
GAAP, including the definition of fair value used, to support the selected
method. ASC 718-10-55-16 states, “A lattice model (for example, a binomial
model) and a closed-form model (e.g., the Black-Scholes formula) are among
the valuation techniques that meet the criteria required by this Topic for
estimating the fair values of employee share options and similar instruments.”
b. Whether the valuation technique is:
i. Applied in a manner consistent with fair value measurement objective and
other objectives of ASC 718, Compensation — Stock Compensation].
ii. Based on the established principles of financial economic theory and
generally applied in that field.
iii. Reflective of all substantive characteristics of the instrument, except for
those explicitly excluded by ASC 718, such as vesting conditions and
reload features. [ASC 718-10-55-11]
iv. In instances where management has determined that different valuation

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methods result in a range of significantly different fair value


measurements, how the entity evaluated the reasons for these differences
in establishing its fair value measurements.
C. Assess the reasonableness of the assumptions used to estimate fair value using option
pricing models by performing the following:
(1) Test the assumptions used in the fair value calculation set forth below for each of the
awards that were granted in the current period and valued using an option pricing
model.
(2) Agree the grant date and corresponding exercise price to appropriate supporting
documentation (e.g., board of directors’ or other appropriate committee (e.g.,
compensation committee) minutes), and documentation of communication of grant to
employee).
[Note: Exercise Price — The exercise price of the option at which the stock or commodity
underlying an option can be purchased or sold. Note: The right to a lower exercise price
may constitute an additional component of value of the option that should be considered at
the grant date.]
(3) Obtain documentation from the entity supporting their estimate of the expected term
of the option, and evaluate the reasonableness of the estimate. Consider the
following:
a. The option’s vesting period. [Note: The expected life of the option is, at a
minimum, as long as the vesting period.]
b. The average length of time similar options have remained outstanding (i.e., the
expected life of the option), including all vested options, even if they were not
exercised (historical exercise behavior and post-vesting employment behavior
for similar grants). The entity should not take into account prevesting employee
termination behavior. Consider situations in which historical information is not
sufficiently complete to enable an entity to use it as the sole basis for estimating
the expected term. If the entity has calculated the historical exercise behavior
based on incomplete historical information, evaluate whether the entity’s
rationale for using this calculation with an estimate of expected term is
reasonable and supportable. Additionally, evaluate whether the entity failed to
make a necessary adjustment to historical exercise behavior. If the entity did
adjust historical exercise behavior, evaluate whether the amount of the
adjustment is reasonable by reviewing the support for the adjustment.
c. Volatility of the underlying stock price.
d. Aggregation of single awards. Based on ASC 718-10-55-34, “[a]n entity shall
aggregate individual awards into relatively homogenous groups with respect to
exercise and post-vesting employment termination behaviors regardless of the
valuation technique or model used to estimate the fair value.”
e. Blackout periods. ASC 718-10-55-29 states that, “some employee share options
contain prohibitions on exercise during blackout periods. To reflect the effect of
those restrictions (which may lead to exercise before the end of the option’s

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contractual term) on employee options relative to transferable options, this


Topic requires that the fair value of an employee share option or similar
instrument be based on its expected term, rather than its contractual term.”
f. Employees’ ages, lengths of service, and home jurisdictions. [ASC 718-10-55-
31]
g. For plain vanilla options, the SEC staff will continue to accept, under certain
circumstances, a “simplified” calculation for options granted after December
31, 2007, if “a company concludes that its historical share option exercise
experience does not provide a reasonable basis upon which to estimate expected
term.” Expected term = ((vesting term + original contractual term) / 2). SAB
107, as amended by SEC Staff Accounting Bulletin 110, codified as part of SAB
Topic 14.D.2, “Certain Assumptions Used in Valuation Methods” (SAB 110),
considers “plain vanilla” options to have the following characteristics: (1) the
share options are granted at-the-money; (2) exercisability is conditional only on
performing service through the vesting date; (3) if an employee terminates
service prior to vesting, the employee would forfeit the share options; (4) if an
employee terminates service after vesting, the employee would have a limited
time to exercise the share options (typically 30-90 days); and (5) the share
options are nontransferable and nonhedgeable.
[Note: Expected Term — The expected term of the option which considers both the
contractual term of the option and the effects of employees’ expected exercise and
post-vesting employment termination behavior. In a closed-form model, the expected
term is an assumption used in (or input to) the model, while in a lattice model, the
expected term is an output of the model. The lattice model will consider such
assumption as expected forfeitures per year and suboptimal exercise factor to derive
the implied expected term. If the entity, after analyzing its historical data, developed a
range of possible expected terms that are each equally likely, verify that the entity
selected the average of the amounts in the range.]
[Note: ASC 718 states that when valuing an employee share option under the Black-
Scholes-Merton framework the fair value of employee share options be based on the
share options’ expected term rather than the contractual term. The vesting period
forms the lower bound of the estimate of expected term.]
h. Agree the price, as of the grant date, of the underlying stock that is used by the
entity to calculate the fair value of the award to appropriate supporting
documentation (e.g., agree to closing stock price as published in “The Wall
Street Journal” or available at www.bloomberg.com). For a nonpublic entity, the
determination of current share price could be based on an appraisal of the
entity’s underlying stock.
[Note: Current Share Price — The current price of the underlying share.]
i. Obtain documentation from the entity supporting its estimate of its stock
volatility and evaluate the reasonableness of the estimate, including how the
entity weights the information and consider the following items:
i. Whether a sufficient number of stock observations made at regular

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intervals are used to compute a statistically valid standard deviation.


Guidance on number of stock observations is provided in SEC Staff
Accounting Bulletin Topic 14.D.1, “Expected Volatility” (SAB 107) [ASC
718-10-S99-1].
ii. Entity’s estimate of the volatility may be comparable to the historical
volatility of the stock over the most recent period that is commensurate
with the expected option life.
iii. If the stock has been trading for a period shorter than the expected life of
the option, the volatility is computed for the longest period for which
trading activity is available. A newly public entity also might consider the
expected volatility of similar entities.
iv. Whether the entity appropriately included or excluded implied volatility of
traded options in its estimation of expected volatility. Consider Question 4
of Topic 14D.1 of SAB 107 [ASC 718-10-S99-1] for instances where
exclusive reliance on either implied or historical volatility is acceptable.
v. A newly public entity (or nonpublic entity) may compare its volatility
assumption against similar entities or an appropriate industry sector index
following a comparable period in their lives.
vi. Changes in an entity’s corporate or capital structure could impact expected
volatility.
vii. Explanation for changes in current year’s estimate of the volatility
compared to the expected volatility that was used in the prior year.
viii. Additionally, for each selection, consider the risk of management override
of the entity’s process for estimating expected volatility.
[Note: Expected Volatility — The expected volatility of the price of the underlying
share for the expected term of the option. Per the ASC Glossary, volatility represents
a measure of the amount by which a financial variable such as a share price has
fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during
a period. The higher the volatility, the more the returns on the shares can be expected
to vary - up or down. Volatility is typically expressed in annualized terms.]
[Note: SAB 107 [ASC 718-10-S99-1] states that the “staff believes that companies
should make good faith efforts to identify and use sufficient information in
determining whether taking historical volatility, implied volatility or a combination of
both into account will result in the best estimate of expected volatility.” Entities
should also consider the availability of new or different information in making this
determination. Historical volatility represents past measure of volatility, while
implied volatility can be imputed from an entity’s publicly traded options. SAB 107
[ASC 718-10-S99-1] further elaborates on implied volatility, “The staff believes that
a company with actively traded options or other financial instruments with embedded
options generally could place greater (or even exclusive) reliance on implied
volatility” (footnote omitted). With respect to historical volatility, ASC 718-10-55-37
indicates entities should consider historical volatility over a period generally
commensurate with the expected term (when a closed-form model is used) or

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contractual term (when a lattice model is used) of the share option. If an entity makes
adjustments to historical volatility based on peer company data, evaluate the
reasonableness of the entity’s decision to use peer company data. Additionally,
evaluate whether the entity is using an appropriate peer group, the entity is reasonably
comparable to the peer group, and its own entity data.]
j. Evaluate the reasonableness of the entity’s estimate of risk-free interest rate for
the expected term of the option used in their model.
[Note: For lattice models incorporating the option’s contractual term, agree the risk-
free interest rate to the U.S. Treasury zero-coupon yield curve over the contractual
term of the option. For closed-form models, agree the risk-free interest rate to the
implied yield currently available on U.S. Treasury zero-coupon issues with a
remaining term equal to the expected term used as the assumption in the model.
Verify that the entity properly calculated the yield based on the traded price. If the
entity interpolated a yield because the expected term fell within the remaining terms
of two bonds, evaluate the accuracy of the interpolation.]
[Note: Risk-Free Rate — The risk-free interest rate(s) for the expected term of the
option. According to ASC 718-10-55-28, a U.S. entity issuing an option on its own
shares must use as the risk-free interest rates the implied yields currently available
from the U.S. Treasury zero-coupon yield curve over the contractual term of the
option if the entity is using a lattice model incorporating the option’s contractual
term. If the entity is using a closed-form model, the risk-free interest rate is the
implied yield currently available on U.S. Treasury zero-coupon issues with a
remaining term equal to the expected term used as the assumption in the model. For
entities based in jurisdictions outside the United States, the risk-free interest rate is
the implied yield currently available on zero-coupon government issues denominated
in the currency of the market in which the share (or underlying share), which is the
basis for the instrument awarded, primarily trades.]
k. Obtain documentation from the entity supporting its estimate of expected
dividends and perform the following:
i. Determine that the entity’s methodology for determining its expected
dividends is reasonable.
ii. Recalculate the amount of expected dividend using a reasonable
methodology.
[Note: Dividends — The expected dividends on the underlying share for the expected
term of the option. ASC 718-10-55-42 states that the “option-pricing models
generally call for expected dividend yield as an assumption. However, the models
may be modified to use an expected dividend amount rather than a yield. An entity
may use either its expected yield or its expected payments. Additionally, an entity’s
historical pattern of dividend increases (or decreases) shall be considered. For
example, if an entity has historically increased dividends by approximately 3 percent
per year, its estimated share option value is not based on a fixed dividend amount
throughout the share option’s expected term. As with other assumptions in an option-
pricing model, an entity uses the expected dividends that would likely be reflected in

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an amount at which the option would be exchanged.”]


(4) Determine that the following items were appropriately excluded from the fair value
assumptions:
a. Reload Feature
b. Contingent Feature
c. Performance and service conditions that affect vesting are not reflected in
estimating the fair value of an award.
[Note: Reload Feature — Per ASC 718-10-30-23, the effect of a reload feature in the terms
of an award shall not be included in estimating the grant-date fair value of the award.
Rather, a subsequent grant of reload options pursuant to that provision shall be accounted
for as a separate award when the reload options are granted.]
[Note: Contingent Feature — A contingent feature of an award that might cause an
employee to return to the entity either equity instruments earned or realized gains from the
sale of equity instruments earned for consideration that is less than fair value on the date of
transfer (including no consideration), such as a clawback feature [ASC 718-10-55-8], shall
not be reflected in estimating the grant-date fair value of an equity instrument. Instead, the
effect of such a contingent feature shall be accounted for if and when the contingent event
occurs. (Note: If the issuer’s practices for stock option grants or its accounting for, and
disclosure of, option grants result in legal or other contingencies, the application of ASC
450, Contingencies, may require that the issuer record additional cost or make additional
disclosures in financial statements.)]
[Note: Performance and service conditions that affect vesting are not reflected in estimating
the fair value of an award. [ASC 718-10-30-27] (Note: Market conditions should be
reflected in the grant date fair value. [ASC 718-10-30-15])]
(5) Evaluate whether the significant assumptions used in measuring fair value, taken
individually and as a whole, provide a reasonable basis for the fair value
measurement of each selection.
Consider among other things, the following:
a. The general economic environment, the economic environment of the entity’s
specific industry, and the entity’s economic circumstances.
b. Existing market information.
c. Assumptions made in prior periods. Compare estimation techniques and
assumptions used in the prior year to those used in the current year. Inquire as to
material variances between the periods. [Note: The variances can also be as a
result of changes in economic conditions.]
d. The entity’s plans and experience, to the extent currently applicable.
D. Evaluate whether the fair value model being used is appropriate considering the entity’s
circumstances (e.g., do the assumptions, methods, and circumstances all form an
appropriate model?)
E. If the entity has changed the valuation technique or model used to value employee share

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options, evaluate whether the new technique or model meets the fair value measurement
objective of ASC 718. The entity should take into account the reason for the change in
technique or model in determining whether it meets the fair value measurement objective.
Additionally, evaluate management’s reason for the change.
F. Test the fair value for each stock option that was valued using an option pricing model,
based on the assumptions tested previously in Procedures A through E, by performing the
following:
(1) For lattice models, where the option-pricing model used by management appears to
comply with the requirements of ASC 718, test the reliability of the model and
determine that the entity’s calculation of fair value for each selection appears
reasonable using the assumptions tested previously in Procedures A through E.
(2) For Black-Scholes or closed-form models, if the option-pricing model used by
management appears to comply with the requirements of ASC 718, test the reliability
of the model and determine that the entity’s calculation of fair value for each
selection appears reasonable using the assumptions tested previously in Steps A
through E.
a. Recompute the entity’s estimate of fair value of the selection by performing the
following for each selection:
i. For a “plain vanilla” application of the Black-Scholes model, input the
data and assumptions tested previously in Procedures A through E into
Form 8350AS, Black-Scholes-Merton Option Pricing Model.
ii. Compare the results from Form 8350A or the work of the Internal Fair
Value Specialist to the entity’s estimated fair value. We would not expect
significant differences, as we would be using the same data and
assumptions.
[Note: The Black-Scholes-Merton option-pricing formula generally would not be an
appropriate valuation model for a share option in which the exercisability is conditional on
a specified increase in the price of the underlying shares because it is not designed to take
into account that type of market condition.]
[Note: We wouldn’t expect significant differences, as we would be using the same data and
assumptions. Discuss any significant differences with the entity to determine the cause of
the discrepancy, and determine if the entity’s option pricing model is reliable. Consider the
impact of differences that, individually or collectively, could be material to the financial
statements.]
(3) If the model used by management does not comply with the requirements of ASC
718, or if the model appears unreliable, this represents at least a control deficiency
which needs to be evaluated and communicated to the entity. In addition, we need to
consult with an Internal Fair Value Specialist for an appropriate response.
G. Consider whether a sensitivity analysis needs to be prepared, based on results of audit
procedures performed in Procedures B through F previously, for comparison to the entity’s
fair value estimate.
[Note: Ordinarily, a sensitivity analysis is prepared when we find:

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 One or more assumption(s) to not be reasonable.


 The valuation methodology is not appropriate.
 A mathematical or computational error is identified in the model.
 If a sensitivity analysis needs to be prepared, identify and use reasonable assumptions,
appropriate valuation methodology, and proper mathematics.]
H. If a sensitivity analysis is prepared, compare the entity’s estimate to the amount (or range
of acceptable amounts) resulting from the sensitivity analysis. Any difference between the
entity’s estimate and the closest reasonable estimate is a misstatement.
I. For those stock options granted and nonvested stock issued to nonemployees where the fair
value of the goods or services received was considered the most reliable measurement of
value, agree the recorded fair value of the option or nonvested stock to the fair value of the
goods or services received.
J. For any nonvested stock issuances that meet one of the following criteria, test fair value
using the market price of the stock by agreeing the recorded fair value of the nonvested
stock award to the market price of the entity’s stock as of the grant date (e.g., agree value
of nonvested stock award to closing stock price as published in “The Wall Street Journal”
or at www.bloomberg.com):
(1) Nonvested stock issued to employees.
(2) Nonvested stock issued to nonemployees when the fair value of the stock is
considered a more reliable measurement than the fair value of the goods and services
received.
[Note: Generally a discount from the fair value of a traded share should not be taken to
value a nonvested share subject to restrictions after vesting. In the absence of objective and
verifiable evidence that supports the fair value of the restricted securities, the best available
evidence of value is the quoted market price of traded securities with similar, but not
identical, characteristics (generally, the similar traded, unrestricted security).]
ACCOUNT BALANCE ASSERTION — INCOME STATEMENT — COMPLETENESS,
ACCURACY, AND CUTOFF

BALANCE SHEET — VALUATION AND ALLOCATION

Possible Procedure 1 — Test Stock-Based Awards for Modifications


A. For each selection made in Possible Procedure 1, Steps F through H to test the Existence,
Rights & Obligations, and Completeness assertions from a balance sheet perspective and
testing of the Occurrence, Completeness, and Cutoff assertions from an income statement
perspective, and for each selection made to test terminated, forfeited or cancelled options
or awards evaluate whether a modification occurred and if so, whether the modification
was appropriately accounted for and recorded in the proper period.
(1) Consider the following:
a. In general, modifications of the terms or conditions of equity awards are treated
as an exchange of the original award for a new award.

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b. Short-term inducements are accounted for as modifications only for those


employees that accepted the inducement offer. Other inducements not meeting
the description of a short-term inducement are modifications of all awards
subject to them.
c. Exchanges of share options or other equity instruments, or changes to their
terms in conjunction with an equity restructuring or business combination, is a
modification with certain limited exceptions.
d. If an award is cancelled and accompanied by a replacement award, it is
generally treated as a modification.
e. Compensation cost should be recognized for repurchases and cancellation of
awards.
ACCOUNT BALANCE ASSERTION — INCOME STATEMENT — CLASSIFICATION

Possible Procedure 1 — Test Stock-Based Awards for Proper Classification


A. Determine that stock-based compensation awards granted in the current period are
appropriately classified as an equity or liability award under the accounting policies of
ASC 718, Compensation — Stock Compensation.
(1) Obtain documentation from management describing the terms of stock-based
compensation awards granted in the current period.
(2) Assess the terms of the stock-based compensation award.
(3) Determine whether management has accounted for the award in a manner consistent
with its classification.

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ACCOUNT BALANCE ASSERTION — INCOME STATEMENT — ACCURACY AND


CLASSIFICATION

BALANCE SHEET — VALUATION AND ALLOCATION

Possible Procedure 1 — Test Compensation Cost


A. Obtain a schedule detailing the amounts of share-based compensation costs recorded in the
current year.
(1) Test the mathematical accuracy of the schedule.
(2) Reconcile the amounts of recorded compensation costs to the compensation costs
included in schedules obtained in Possible Procedure 1 to test the existence, rights &
obligations and completeness assertions from a balance sheet perspective and testing
of the occurrence, completeness and cutoff assertions from an income statement
perspective and test the reconciling items.
(3) Agree compensation costs from the schedules to the general ledger.
B. To test the entity’s ASC 718 share-based compensation expense for stock options,
nonvested stock, and temporary equity granted in the current year, perform the following:
(1) For awards selected in Steps F through H for Possible Procedure 1 to test the
Existence, Rights & Obligations, and Completeness assertions from a balance sheet
perspective and testing of the Occurrence, Completeness, and Cutoff assertions from
an income statement perspective that represent beginning balance and current-year
awards, recalculate the amount of compensation cost for the current year, and agree it
to the schedule. Also agree the offsetting entry into additional paid-in capital,
temporary equity, or liabilities, as applicable. As applicable, perform the following in
recalculating the compensation expense:
a. For share-based awards classified as equity, determine the requisite service
period.
b. If an award vests upon the satisfaction of a service condition or one or more
performance conditions, determine that the requisite service period has been
estimated based on the probabilities of achieving each outcome. [ASC 718-10-
30-26 and 35-7]
c. If an award contains a market condition and a performance or service condition
and the initial estimate of the requisite service period is based on the market
condition’s derived service period, has the requisite service period not been
revised unless the following conditions have been met: [ASC 718-10-50-2]
i. The market condition is satisfied before the end of the derived service
period, and
ii. Satisfying the market condition is no longer the basis for determining the
requisite service period.
[Note: The requisite service period is the period an employee is required to provide service

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in exchange for an award, based on the analysis of the terms of the share-based payment
award. (See ASC 718-10-55-69 through 55-79 and 55-93 through 55-106 for additional
guidance in determining explicit, implicit, and derived service periods.)]
(2) Recompute the total compensation cost using the fair value tested above, the number
of awards granted, and the number of instruments for which the requisite service is
expected to be rendered.
a. Determine whether the compensation expense to be recognized has been revised
if subsequent information indicates that the actual number of instruments for
which the requisite service is expected to be rendered changed from the original
grant date estimate.
b. If a cumulative change in estimate has occurred, determine if it has been
recognized as compensation expense in the period of change.
(3) Recompute the amount recognized as expense in the current year by performing the
following:
a. If the award relates to past services, determine that the fair value of the award is
charged to earnings (i.e., compensation expense) in the period the options are
granted.
b. If the options are granted for future services, determine that the compensation
cost is amortized over the period in which the related services are rendered or
the period from the grant date to the date that the award is vested, whichever is
shorter.
c. Determine whether the entity has properly considered performance-related or
market-related conditions and graded vesting schedules when recognizing
compensation costs.
d. For an award with only service conditions that has a graded vesting schedule,
determine whether the amount of compensation cost recognized at any date is at
least equal to the portion of the grant-date fair value of the award that is vested
at that date.
e. Determine whether the compensation cost related to awards with a performance
condition have been accrued only if it is probable that the performance
condition will be achieved. For awards with multiple performance conditions,
determine that the interrelationships of all performance conditions have been
assessed to determine the probability of satisfying the performance conditions.
[ASC 718-10-25-20]
[Note: The entity must make a policy decision about whether to recognize compensation
cost for an award with only service conditions that has a graded vesting schedule on a
straight-line basis over the requisite service period (a) for each separately vesting portion of
the award as if the award were, in substance, multiple awards or (b) for the entire award.
[ASC 718-10-35-8]]
(4) In the event that an employee renders the requisite service for a share option or share
unit (equity award), and the award expires unexercised or unconverted, determine that
the entity has not reversed previously recognized compensation cost.

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(5) For an award that requires satisfaction of one or more market, performance, or service
conditions (or any combination thereof), determine that compensation cost has been
recognized only if the requisite service has been rendered.
(6) For awards with market, performance, and service conditions (or any combination
thereof), determine that the final measure of compensation cost has been based on the
amount estimated at the grant date (i.e., grant-date fair value) for the condition or
outcome that is actually satisfied.
[Note: Market, performance, or service conditions that affect an award’s exercise price,
contractual term, quantity, conversion ratio, or other factors shall be considered in
measuring the grant-date fair value.]
C. For awards classified as liabilities, make selections from the detail supporting both the
beginning balance and current-year activity as illustrated in the schedule obtained in Step B
in Possible Procedure 1 to test the Existence assertion. For each selection, recalculate the
amount of compensation expense and the liability at the end of the year.
(1) In doing so, consider the following:
a. If the changes in fair value or intrinsic value (under ASC 718-30-30-2, a
nonpublic entity shall make a policy decision of whether to measure all of its
liabilities incurred under share-based payment arrangements at fair value or to
measure all such liabilities at intrinsic value) of a liability award that occurred
during the requisite service period have been recognized as compensation cost
over that period.
b. If the percentage of fair value or intrinsic value that is accrued as compensation
cost at the end of each period is equal to the percentage of requisite service that
has been rendered at that date.
c. If the changes in fair value or intrinsic value of a liability award that occurred
after the end of the requisite service period have been recognized as
compensation cost in the period in which the changes occur.
d. If any difference between the amount for which a liability award is settled and
its fair value or intrinsic value at the date of settlement has been recognized as
an adjustment of compensation cost in the period of settlement.
D. For each selection that resulted in expense recognition, determine whether the expense is
classified in the proper accounts (e.g., cost of sales, component of operating expenses).
ACCOUNT BALANCE ASSERTION — INCOME STATEMENT — COMPLETENESS,
ACCURACY, AND CUTOFF

BALANCE SHEET — VALUATION AND ALLOCATION

Possible Procedure 1 — Test Compensation Cost for Appropriate Cutoff


A. For awards selected in Steps F through H for Possible Procedure 1 to test the Existence,
Rights & Obligations, and Completeness assertions from a balance sheet perspective and
testing of the Occurrence, Completeness, and Cutoff assertions from an income statement

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perspective, perform the following:


(1) Determine that the recognition of compensation cost began at the appropriate time,
considering service inception date and grant date.
[Note: ASC 718-10-35-6 states, “The service inception date is the beginning of the
requisite service period. If the service inception date precedes the grant date, accrual of
compensation cost for periods before the grant date shall be based on the fair value of the
award at the reporting date. In the period in which the grant date occurs, cumulative
compensation cost shall be adjusted to reflect the cumulative effect of measuring
compensation cost based on fair value at the grant date rather than the fair value previously
used at the service inception date (or any subsequent reporting date).”]
ACCOUNT BALANCE ASSERTION — INCOME STATEMENT — OCCURRENCE,
COMPLETENESS AND CUTOFF

BALANCE SHEET — EXISTENCE, RIGHTS AND OBLIGATIONS, AND


COMPLETENESS

Possible Procedure 1 — Test the Schedule of Stock-Based Awards


A. Test the schedule of awards activity obtained in Step A and B of Possible Procedure 1 for
testing of Existence, Rights & Obligations, and Completeness assertions from a balance
sheet perspective and testing of the Occurrence, Completeness, and Cutoff assertions from
an income statement perspective and the obligation of recorded stock-based awards by
making inquires of those independent of accounting who are responsible for monitoring the
issuance of stock options and other share-based awards (e.g., the Corporate Secretary) and
reading the minutes of the board of directors or other appropriate committees (e.g.,
compensation committee) to identify options or other awards that have been granted,
exercised, forfeited, modified, or expired during the year that may not have been recorded
on the schedule.
ACCOUNT BALANCE ASSERTION — INCOME STATEMENT — COMPLETENESS
AND ACCURACY OF DEFERRED TAX BENEFITS

BALANCE SHEET — COMPLETENESS AND VALUATION AND ALLOCATION OF


DEFERRED TAX ASSETS

Possible Procedure 1 — Test Deferred Tax Assets/Benefits Associated with


Stock-Based Compensation
A. In using this portion of the guide, consider involving an Employee Benefits Tax
professional who will be familiar with many different types of equity compensation,
particularly if the entity has net operating losses, stock awards to non-U.S. employees,
modifications to stock awards, corporate transactions, or other factors which may provide
additional complexities in accounting for the income tax implications of ASC 718.
B. For each selection obtained in Steps A and B of Possible Procedure 1 to test the Existence,
Rights & Obligations, and Completeness assertions from a balance sheet perspective and
testing of the Occurrence, Completeness, and Cutoff assertions from an income statement

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perspective that represents an award for which compensation cost is recognized in the
current year, identify if the award would ordinarily result in a tax deduction under the
existing tax law. [ASC 718-740-25-2 through 25-4]
(1) For each of the selections that would ordinarily result in a future tax deduction,
determine that the compensation costs recognized is considered a temporary
difference in applying FASB Statement No. 109, Accounting for Income Taxes, such
that a deferred tax benefit and corresponding deferred tax asset is recognized. [ASC
718-740-25-2 through 25-4]
(2) For each of the selections, determine the deferred tax benefit (or expense) that
resulted from an increase (or decrease) in that temporary difference has been
recognized in the income statement. [ASC 718-740-25-2 through 25-3]
(3) For each of the selections that would not ordinarily result in a future tax deduction,
determine that no tax effects have been recognized until an event that results in a
future tax deduction occurs (e.g., under U.S. tax law, an employee’s disqualifying
disposition of shares). [ASC 718-740-25-2 through 25-3]
[Note: The grant of discounted stock options may affect the issuer’s ability to deduct
expenses related to these options for income tax purposes, thereby affecting the issuer’s
cash flows and the accuracy of the related accounting for the tax effects of options.]
C. For each selection obtained in the procedures above that represents an award for which an
event has occurred that will result in an entity taking a tax deduction in the current period,
determine that differences between (1) a tax deduction related to share-based compensation
that is reported or will be reported in the entity’s tax return and (2) the cumulative
compensation cost recorded in the financial statements associated with those awards, are
accounted for appropriately.
(1) Obtain an analysis of any deductions for share-based payment awards that exceed the
cumulative compensation cost recognized in the financial statements, and determine
that the excess tax benefit is recognized as additional paid in capital.
[Note: Per ASC 718-740-35-3, “If a deduction reported on a tax return for an award of
equity instruments exceeds the cumulative compensation cost for those instruments
recognized for financial reporting, any resulting realized tax benefit that exceeds the
previously recognized deferred tax asset for those instruments” (the excess tax benefit)
shall be recognized as additional paid-in capital.
However, realized tax benefits previously recognized in additional paid-in capital should be
reclassified to the income statement whenever the entity’s forfeiture estimate increases or if
actual forfeitures exceed its estimates. The amount reclassed is limited to the additional
paid-in capital pool balance on the reclassification date.]
(2) If the deduction for share-based payment awards is less than the cumulative
compensation cost recognized for financial reporting purposes, then determine that:
a. The write-off of a deferred tax asset related to that deficiency, net of the related
valuation allowance, if any, is first offset to the extent of any remaining
additional paid-in capital from excess tax benefits from previous awards
accounted for in accordance with ASC 718, or, if elected, the amounts computed

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using the alternative transition method described in FSP FAS 123(R)-3.


Recalculate and test the entity’s analysis that there is sufficient additional paid-
in capital to offset tax benefit deficiencies and conclude it is appropriate that the
write-offs are appropriately recorded in additional paid-in capital. [ASC 718-
740-35-5 and 35-7]
b. The remaining balance, if any, of the write-off of a deferred tax asset related to a
tax deficiency is recognized in the income statement. [ASC 718-740-35-5 and
35-7]
c. If the entity continued to use the intrinsic value method of APB Opinion No. 25,
Accounting for Stock Issued to Employees, as permitted by FASB Statement No.
123, Accounting for Stock-Based Compensation, verify the entity calculated the
amount available for offset (the APIC pool) as the net amount of excess tax
benefits that would have qualified as such had it instead adopted FASB
Statement 123 for recognition purposes pursuant to FASB Statement 123’s
original effective date and transition method. [ASC 718-740-35-5 and 35-7]
In determining that amount, verify no distinction has been made between excess
tax benefits attributable to different types of equity awards, such as restricted
shares or share options. Additionally, verify the entity has excluded from that
amount both excess tax benefits from share-based payment arrangements that
are outside the scope of ASC 718, such as employee share ownership plans, and
excess tax benefits that have not been realized pursuant to ASC 740, Income
Taxes. [ASC 718-740-35-5 and 35-7]
D. The following are accounting and disclosure requirements that may be applicable to this
entity:
(1) Has the entity determined that differences between (1) the deductible temporary
difference computed pursuant to Steps B.1 through B.3 above and (2) the tax
deduction that would result based on the current fair value of the entity’s shares, are
not being considered in measuring the gross deferred tax asset or determining the
need for a valuation allowance for a deferred tax asset recognized? [ASC 718-740-
30-2]
(2) Has the excess tax benefits that stem from a reason other than a change in the fair
value (or calculated value) of the company’s shares between the measurement date
for accounting purposes and a later measurement date for tax purposes been
recognized in the income statement? [ASC 718-740-45-2]
a. If the entity has adopted EITF Issue No. 06-11, Accounting for Income Tax
Benefits of Dividends on Share-Based Payment Awards, the previous question
would be substituted with the following question:
Have the excess tax benefits that stem from a reason other than (1) a change in the
fair value (or calculated value) of the company’s shares between the measurement
date for accounting purposes and a later measurement date for tax purposes or (2)
related dividends or dividend equivalents charged to equity, been recognized in
the income statement? [ASC 718-740-45-2; EITF 06-11]

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OPERATING EXPENSES

ACCOUNT BALANCE ASSERTION — OCCURRENCE OF OPERATING


EXPENSES

Possible Procedure 1 — Perform Substantive Analytical Procedures on


Operating Expense Transactions for the Current Period
A. Perform substantive analytical procedures to test the operating expense transactions by
performing the following:
(1) Develop an expectation of the operating expense amount for the current period using
appropriate data.
(2) Disaggregate both the data used to build the expectations and the various recorded
operating expense amounts at a level of detail sufficient to enable us to identify
material misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and

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examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

Possible Procedure 2 — Perform Tests of Details on Operating Expense


Transactions
A. Make an audit sample of operating expense transactions from the general ledger. For each
selection, obtain evidence of occurrence by agreeing to one of the following:
(1) An invoice or supplier statement, if the expense was recorded with a corresponding
credit to payables (or paid directly with cash).
(2) A computation (the underlying details of which are tested), based on a contract,
invoice, and/or other document(s), if the expense was recorded with a corresponding
credit to an accrued expense account.
(3) A computation (which should be tested) if the expense was recorded with a
corresponding credit to a prepaid expense account.
(4) Consider the selected items to have misstatements equal to the book value of the
unsupported amounts for the purpose of evaluating the audit sample.
B. Test that each selection is appropriately classified as an operating expense.

Possible Procedure 3 — Using Analytical Procedures and/or Tests of Details to


Update Occurrence Tests Performed at an Interim Date
A. Make inquiries of the entity’s operations personnel regarding their knowledge of any
unusual terms or conditions associated with transactions between the interim testing date
and year-end balance sheet date.
B. Perform substantive analytical procedures to test the account balance change in the
intervening period (i.e., from the interim-test date to the balance sheet date).
(1) Develop expectations of the account balance change in the intervening period
considering factors identified during the interim test as well as those identified during
inquires made.
(2) Determine threshold.
(3) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.
And/or
C. Perform test of details on account balance change in the intervening period (i.e., from the
interim-test date to the balance sheet date) and trace to supporting documentation.

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ACCOUNT BALANCE ASSERTION — COMPLETENESS OF OPERATING


EXPENSES

Possible Procedure 1 — Perform Substantive Analytical Procedures on


Operating Expense Transactions for the Current Period
A. Perform substantive analytical procedures to test the operating expense transactions by
performing the following:
(1) Develop an expectation of the operating expense amount for the current period using
appropriate data.
(2) Disaggregate both the data used to build the expectations and the various recorded
operating expense amounts at a level of detail sufficient to enable us to identify
material misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

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Possible Procedure 2 — Perform Test of Details on a Population Independent of


Recorded Operating Expenses
A. Make an audit sample of credits to account payables or accrued expenses or items from
other independent source records corresponding to operating expense transactions. For
each selection, perform the following:
(1) Trace the item to a vendor’s invoice and final sales contract or purchase order (if
applicable).
(2) If supporting documentation of the credit to account payables or accrued expenses
indicates that the nature of cost is an operating cost, trace to proper inclusion in the
operating expense general ledger account.

ACCOUNT BALANCE ASSERTION — ACCURACY OF OPERATING EXPENSES

Possible Procedure 1 — Perform Test of Details on the Accuracy of Operating


Expense Transactions
A. For the selections made to test Occurrence of operating expense transactions (Possible
Procedures 2 and 3 (if tests of details were chosen to update Existence tests at an interim
date) — for the Occurrence assertion above), perform the following:
(1) Test the computation of recorded amounts if the expense was recorded with a
corresponding credit to payables (or paid directly with cash) based on contract,
invoice, and/or other document(s).
(2) Test the computation of recorded amounts if the expense was recorded with a
corresponding credit to an accrued expense account.

Possible Procedure 2 — Perform Substantive Analytical Procedures on


Operating Expense Transactions for the Current Period
A. Perform substantive analytical procedures to test the operating expense transactions by
performing the following:
(1) Develop an expectation of the operating expense amount for the current period using
appropriate data.
(2) Disaggregate both the data used to build the expectations and the various recorded
operating expense amounts at a level of detail sufficient to enable us to identify
material misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit

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evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

ACCOUNT BALANCE ASSERTION — CUTOFF OF OPERATING EXPENSES

Possible Procedure 1 — Operating Expense Cutoff Considerations


A. For the selections made to test Occurrence of operating expenses (Possible Procedure 2 —
for the Occurrence assertion above), perform the following:
(1) Determine that each debit was recorded in the correct period.

Possible Procedure 2 — Perform Substantive Analytical Procedures on


Operating Expense Transactions for the Current Period
A. Perform substantive analytical procedures to test the operating expense transactions by
performing the following:
(1) Develop an expectation of the operating expense amount for the current period using
appropriate data.
(2) Disaggregate both the data used to build the expectations and the various recorded
operating expense amounts at a level of detail sufficient to enable us to identify
material misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:

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a. If the data is not independent, separately audit the data.


b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.
(4) Determine the threshold.
(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

Possible Procedure 3 — Test Cutoff of Expenses


A. Make an audit sample of recorded operating expenses in the [x]-day period prior and
subsequent to year-end. Document the rationale for days selected. For each selection,
perform the following:
(1) Trace the selected expenses to invoices, receiving reports, purchase orders, or other
support evidencing when goods were received or services were rendered.
(2) Determine that the expenses were recorded in the correct period by tracing the
selection to the general ledger.

ACCOUNT BALANCE ASSERTION — CLASSIFICATION OF OPERATING


EXPENSES

Possible Procedure 1 — Perform Tests of Details on Operating Expense


Transactions
A. Using the same selections from the Occurrence and Completeness tests for operating

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expenses (Possible Procedure 2 and Possible Procedure 1 above, respectively), ascertain


that the benefits associated with such costs did not extend the life of a current asset or
exceed one operating cycle and therefore do not qualify to be capitalized.
B. Using the selections to test additions to property for Existence, ascertain that benefit
associated with such costs exceed an operating cycle or extend the useful life of an existing
asset.
C. Make an audit sample of repair and maintenance expense, obtain the invoice and other
related support, and determine whether such expenses were properly classified as a period
cost.

Possible Procedure 2 — Perform Substantive Analytical Procedures on


Operating Expense Transactions for the Current Period
A. Perform substantive analytical procedures to test the operating expense transactions by
performing the following:
(1) Develop an expectation of the operating expense amount for the current period using
appropriate data.
(2) Disaggregate both the data used to build the expectations and the various recorded
operating expense amounts at a level of detail sufficient to enable us to identify
material misstatements.
(3) Determine that the data used to develop our expectation is independent and reliable
and, if we are using information produced by the entity, that it is accurate and
complete by considering the following:
a. If the data is not independent, separately audit the data.
b. In assessing the reliability of the data gathered, consider the source of the data
and the conditions under which it was gathered.
c. For information that we are using that is produced by the entity, obtain audit
evidence about the accuracy and completeness of the data by either of the
following means:
i. Perform tests of the operating effectiveness of controls over the
production and maintenance of the information. [Note: Tests of operating
effectiveness of general computer controls alone do not provide assurance
over the accuracy and completeness of information produced by the
entity.]
ii. Perform audit procedures directly on the information being relied upon.
These procedures may include either of the following:
(a) Reproducing the information, using the entity’s underlying data and
file-interrogation software on computer-generated information.
(b) Agreeing summary information to underlying data or third-party
source documents and tracing a selection of information from the
entity’s underlying data or third-party source documents into the
information.

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(4) Determine the threshold.


(5) Compare the expectation to the recorded amount and identify any differences. For
any difference that is more than the threshold, obtain, quantify, and corroborate
explanations for the difference by performing further analysis or inquiry and
examining supporting documents. Explanations need to be sought for the full amount
of the difference, not just for the part that exceeds the threshold.

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INTEREST EXPENSE

ACCOUNT BALANCE ASSERTION — OCCURRENCE, COMPLETENESS,


ACCURACY, CUTOFF, AND CLASSIFICATION OF INTEREST EXPENSE

Possible Procedure 1 — Test Interest Expense


A. Obtain the debt schedule(s) and the reconciliation of the schedule(s) to the general ledger
(which may be obtained in Possible Procedure 1 within the testing of the Rights and
Obligations Assertion of Notes Payable and Long-Term Debt above).
B. Make an audit sample from the schedule of debt.
C. For those items selected in B above, calculate overall interest expense on loans for the year,
and compare with recorded interest expense.

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NOTES

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1
For the purposes of this guide, alternative investments encompass investments in private investment funds.
Examples of private investment funds include hedge funds, private equity funds, real estate funds, venture capital funds,
commodity funds, offshore fund vehicles, fund of funds or bank common/collective trust funds. Alternative investments
may be structured as limited partnerships, limited liability corporations, trusts, or corporations.
2
For the purposes of this guide, direct investments include investments that are not traded on a national level, or
 Recognized on international exchanges or over-the-counter markets, or
 For which quoted market prices are not available from sources such as financial publications, the exchanges, or the
National Association of Securities Dealers Automated Quotations (NASDAQ) system.
3
For the purposes of this guide, the balance sheet dates of the entity and the alternative investment must be the
same.
4
Per U.S. AAM 620 02a, We shall request the confirmation of accounts receivable unless one of the following
is true:
 Accounts receivable are not material to the Financial Statements.
 The use of confirmations would be ineffective.
 We are planning a low extent of substantive testing and the evidence expected to be provided by Analytical
Procedures or other substantive Test of Details is sufficient to reduce audit risk to an acceptably low level. In
many situations, both confirmation of accounts receivable and other substantive Tests of Details are necessary to
reduce Audit Risk to an acceptably low level. [AICPA AU 330.34, PCAOB AU 330.34]

02b If we do not request confirmation of accounts receivable, we shall document the basis for such
determination. [AICPA AU 330.35, PCAOB AU 330.35]
5
Per U.S. AAM G645.19a, We shall consult with the Audit PPD if inventory is material to the Financial
Statements and we did not attend the physical inventory count and do not plan to make reference in our audit
report to a scope limitation.
6
Another possible procedure that can be performed to test the Occurrence of Sales is to test the Occurrence
of Sales for the selections made to test the Existence of Accounts Receivables and combine this test with the
performance of analytic procedures, such as analysis of key ratios involving sales and accounts receivable. The
appropriate procedures to test the Occurrence of Sales is a matter of professional judgment and involves
considerations regarding the level of complexity of sales and other relevant circumstances.