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Chapter 10

Finance and Investment Cycle

“Credit has done a thousand times more to enrich mankind than all
the goldmines in the world. It has exalted labor, stimulated manufacture
and pushed commerce over every sea.”
--Daniel Webster

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Presentation Outline
I. Overview of Finance and Investing
Cycle
II. Audit of Liabilities and Stockholders’
Equity
III. Audit of Investments

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I. Overview of Finance and

Investing Cycle
A. Investing and Financing Cycle Activities
B. Inherent Risks
C. Investment and Finance Activities
D. Control Considerations
E. Finance and Investment Cycle: Control
Procedures
F. Control Over Accounting Estimates

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A. Investing and Financing

Cycle Activities
• Concerned with transactions related to the use of
the organization's funds (investing) and sources of
those funds (financing) other than operations.
• Accounts affected by investing and financial cycle
transactions include investments in securities;
property, plant and equipment; notes and bonds
payable; and, stockholders' equity accounts.

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

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

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D. Control Considerations
• Transactions authorized by BOARD OF DIRECTORS
• Documentation:
– Investments in securities: BROKER'S ADVICE
– Property, plant and equipment: VENDOR'S INVOICE
(for purchased PPE) or INTERNAL COST RECORDS
(for manufactured PPE)
– Bonds and notes payable: Documentation from
DEBTHOLDERS
– Stockholders' Equity: Documentation from
REGISTRAR
• CASH RECEIPTS/DISBURSEMENTS JOURNALS
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E. Finance and Investment Cycle:
Control Procedures
• Physical Controls
– Securities numbered and in the client's name
– Securities held by an independent custodian or in a secure location
– Access to safe-deposit box requires the presence of more than one
employee
– Physical items periodically compared to detail records
– Cash receipts from Investing and Financing cycle transactions
deposited intact and daily
• Segregation of Duties
– Transactions AUTHORIZED by the Board of Directors
– General Accounting RECORDS transactions
– A separate function or external custodian has CUSTODY
• Performance Reviews
– Compare current investing and cycle transaction data against prior-
year data or expected data
– Compare revenue and expenses against organization standards or
expectations.

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 F. Control Over Accounting 10-10

Estimates
A sample of accounting estimates are provided on
the top of p. 368. Specific aspects of estimate
development an auditor considers include:

• Management emphasis on proper estimation

• Accumulation of sufficient relevant data from reliable
sources
• Qualified personnel prepare estimates
• Review and approval at appropriate levels of authority
• Comparison of prior estimates to results to evaluate
reliability of estimate approach.
• Determine if estimates are consistent with current
company plans and operations.
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II. Audit of Liabilities and

Stockholders’ Equity
A. Substantive Testing for Interest-Bearing
Liabilities
B. Audit Documentation – Exhibit 10.4
C. General Audit Concerns for Stockholders’
Equity
D. Auditing Paid-in Capital
E. Auditing Retained Earnings

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A. Substantive Testing for Interest-

Bearing Liabilities
• Agree to BEGINNING BALANCE and CONFIRM
with holders or makers.
• LOAN PROCEEDS
– VOUCH to cash receipts
– Recalculate Discount/Premium
– Examine note for interest, payment terms, collateral, debt
covenants, etc.
• LOAN PAYOFF
– Recalculate Interest Expense
– Recalculate Gain/Loss on Retirement
– Verify cash disbursements

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A. Substantive Testing for Interest-

Bearing Liabilities (Continued)
• INTEREST PAYMENTS
– Recalculate Interest Expense
• Search for UNRECORDED liabilities
– Inquiry of management
– Bank confirmations
– Unusual amounts of interest expense
– Large receipts of cash during the year
• Ensure DEBT COVENANTS are met.
– Inspect loan agreements.
– Consider GOING CONCERN implications if not met.
– Ensure proper presentation and disclosure.

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B. Audit Documentation – Exhibit 10.4

p. 371

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C. General Audit Concerns for

Stockholders’ Equity
• Overview of audit approach
– EXTERNAL PARTIES involved in record keeping can
confirm stockholders’ equity. Otherwise, items can be
vouched to the certificate book stubs.
– Transactions must be authorized by the BOARD OF
DIRECTORS
– Transactions must be consistent with the client's
ARTICLES OF INCORPORATION

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D. Auditing Paid-in Capital

– Agree balances to prior year documentation
– Examine issuances and repurchases of capital stock
• Verify distribution of proceeds between CAPITAL STOCK
and ADDITIONAL PAID-IN CAPITAL
• Examine CASH RECEIPTS and CASH DISBURSEMENTS
records
• Determine that all transactions are RECORDED (TRACE
from BOD minutes)
• Verify that all transactions are PROPERLY AUTHORIZED

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E. Auditing Retained Earnings

– Agree beginning balance with prior year documentation

– Verify the appropriateness of prior-period adjustment
treatment
– Trace net income/loss to INCOME STATEMENT
– Ensure that DIVIDENDS are properly authorized by
BOARD OF DIRECTORS

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III. Audit of Investments

A. Substantive Audit Procedures for
Investments
B. Trouble Spots in the Audit of Investments

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A. Substantive Audit Procedures for

Investments
• Agree balances to Prior Year Documentation
• Purchases of investments
– VOUCH to BROKER'S ADVICE (Statement)
– Examine BOARD MINUTES for authorization
• Sales of investments
– VOUCH to BROKER'S ADVICE, CASH RECEIPTS
RECORDS, and BOARD MINUTES
– Recalculate gain or loss on sale
– Read minutes for sales of Investments and trace to
recording

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A. Substantive Audit Procedures for

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

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B. Trouble Spots in the Audit of
Investments

• Valuation of investments at cost, market, or value

impairment that is other than temporary.
• Propriety, effectiveness, and risk disclosure of
derivative securities used as a hedges
• Determination of the fair value of derivatives and
securities, including valuation models and the
reasonableness of key assumptions.
• Determination of significant influence relationship
for equity method investments.

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Summary
• Accounts involving Investments, Property-Plant
and Equipment, Debt, and Equity
• Inherent risk for leases, loan covenants, related
parties, complex transactions, and big baths
• Estimate process and evaluation
• Audit of liabilities and stockholders’ equity
• Value of investments and amount of investment
income

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