Internal control over investments requires strong segregation of the following duties:
Authorization of Purchase or Sale of Investments: Ideally, the board of directors should authorize the purchase or sale of investments.
Custody of Investments: An independent, third-party custodian is recommended but, at minimum, custody should take the form of joint control by two company officials with the investments kept in a safe-deposit box. If held by the company, the investments should be periodically counted and reconciled with the investment subsidiary ledger by a party not associated with the investments.
Record Keeping: A separate party from those mentioned above must keep detailed records of the investments.
Internal controls should also exist regarding processing and fair value measurement. The initial classification of investments as trading, available-for-sale, or held to maturity significantly impacts subsequent reporting. Controls surrounding fair value estimates, whether inside the company or outside the company (should a third party be used to assess fair value), also must be understood.
Sufficient audit evidence must be obtained by the auditor for investments which may be in the form of debt and equity investments, and loan and advance accounts. Substantive tests of details related to the investment cycle generally focus on the ending balance in the investment accounts and presentation and disclosure. Analytical procedures are used to test the reasonableness of related gains and losses and investment income.
Equity securities and debt securities classified as trading or available-for-sale over which the investor has no significant influence should be carried at fair value, and classification of Level 1, 2, or 3 should be disclosed in the footnotes. Held-to-maturity debt securities should be carried at amortized cost.
Equity investments and debt investments classified as trading securities are always reported as current assets with unrealized gains and losses reported in net income. Available-for-sale debt securities and held-to-maturity debt securities are reported as current or long-term based on management's intent to hold versus sell. Unrealized gains and losses on available-for-sale securities are reported in other comprehensive income.
The auditor should inquire of management and obtain written representation concerning management's intent and ability with respect to holding versus selling securities in the near term.
Certain financial assets and liabilities, such as marketable securities are presented or disclosed at fair value in the financial statements.
Fair value is defined as the amount at which an asset could be sold (or the amount at which a liability could be settled) in a current transaction between willing parties at the measurement date. A three-level hierarchy is used to measure fair value.
Level 1: Observable quoted prices in active markets for identical assets or liabilities. Quoted prices from national exchanges or over-the-counter markets are available from national publications and the exchanges, and generally are considered to provide sufficient evidence of the fair value of the derivatives and securities. If a quoted market price is available, this should be the method used to determine the fair value of the investment.
Level 2: Observable inputs other than quoted market prices for identical assets or liabilities. When quoted prices for identical assets or liabilities are not available, the next consideration is whether there are other directly or indirectly observable inputs. The most common of these observable inputs are quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets in markets that are not active.
Level 3: Unobservable inputs using estimates and valuation methods, such as discounted cash flow, determined based on management's judgments.
If quoted prices are not available, estimates of fair value may be available from broker-dealers or other third-party sources based on proprietary valuation models or from the entity based on an internal valuation model. The auditor should ensure that the pricing source does not have a relationship that would impair objectivity in determining fair value. The auditor should also consider obtaining further estimates if subjective information was used in the valuation process.
Which of the following would an auditor least likely consider with respect to fair values?