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1. Does the internal audit department conduct regular audits of the controls over
marketable securities? If yes, review recent reports. (b)
2. If management has changed the classification of securities during the year from either
trading securities or available-for-sale securities to held-to-maturity securities, are the
amounts significant? Were they reviewed by the audit committee? Do the audit
committee and the board concur with the change? (b)
3. Does the company regularly invest in marketable securities? How material are the
balances in marketable securities accounts? (a)
4. Does the company have written policies and guidelines regarding investments in
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a. The board of directors does not monitor policies regarding marketable securities.
The auditor would assess control risk as higher. More importantly, the auditor would be
concerned if the company had material investments in marketable securities and would
need to perform an independent assessment of the risk associated with the securities. In
b. The company’s internal auditors do not have any computer audit expertise and have not
conducted audits of the cash or marketable securities account during the past three years.
The auditor’s main concern is that an important part of the overall control environment is
not operating. Since there are no internal audits, the auditor should consider that factor in
c. Management does not have written guidelines for investments in marketable securities. The
financial executive has been successful in procuring good returns on investments in the past and
management does not want to tamper with success.
Assess risk as higher. This is a concern because there is no independent oversight of
management’s investments. Past short-run returns on investments in management securities
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The audit procedures that would be applicable to completing the audit of marketable securities
include:
1. All beginning balance figures (Marketable securities, allowance, and general ledger):
2. Marketable Securities (ending balance):
• Obtain a detailed trial balance of the securities constituting the year-end balance. Either
3. Allowance to Reduce Securities to Market Value:
• Obtain the Wall Street Journal or some other financial reporting service indicating the
market value of the securities at the end of the year. Use the reported market value and
4. Interest Income:
• Use the list from the trial balance to obtain information on the amount of interest bearing
securities held during the year, the interest rate, and the time period held for each security.
5. Dividend Income:
• Similarly to step 4, obtain a listing of the securities held, etc. Use a standard dividend
6. Net Gain on Disposal of Securities:
7. Determine that the securities are properly classified.
The investments in securities are classified as:
1. Held-to-maturity
The held-to-maturity securities are valued at amortized cost, subject to an impairment test. The
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a. Identification of areas of inherent risk (including fraud risk) and control risk:
2. Company is intent on a “turnaround” and appears to be willing to take unusually high
risks to accomplish a greater reported return.
3. The company is shifting its major business from manufacturing to high risk investments.
5. The audit committee does not enhance the independence of the internal audit department.
7. The investment account has grown to 30% of assets and contains many “high fliers.”
9. There may be problems with a related party transaction with the brokerage fees.
10 There is a question over the control of the securities. The fact that the securities are
distributed in three locations may indicate that the securities are more susceptible to
manipulation.
b. Outline of an Audit Program
The audit program for the company must recognize the existence of a high level of risks inherent
in the investment portfolio. These risks include the number of places in which the securities are
held, the related party nature of the transactions, and the increasing risk associated with the
investment portfolio.
1. Ask the client to prepare a working paper schedule of marketable securities for the year
2. Test the existence of the marketable securities held at year-end as follows:
• Assuming the brokerage company is an independent, reputable company, confirm the
year-end holdings directly with the brokerage company.
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3. For securities where a ready market value is available at year-end (and the auditor
4. For securities where the market is thin, or there is question about the market value of the
securities:
• Request a market value estimate from the independent brokerage firm – including an
5. Review selected purchases during the year by reference to broker’s advices and cash
disbursements to verify the cost of the securities.
6. Review selected disposals during the year by reference to broker’s advices and cash
7. Use an independent reporting service and recompute the amount of interest or dividend
8. Review any internal audit reports on marketable securities or operation of the securities
account during the year.
9. Review and schedule all the transactions with the consulting company during the year.
10. Evaluate the fairness of financial presentation. Document the assessment in an audit
working paper.
c. There are many factors that the auditor would evaluate in forming an opinion on
Tone at the Top:
• Complete control is in the hands of one person.
• There is very little risk analysis.
• There is little monitoring of the investment activities.
• Compensation package encourages high risk taking because it emphasizes above normal
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Other Control Issues:
• No specific authorization for securities not held at brokerage house
• There is no specific review of independent authorization of the stock holdings.
Although the company is doing well, it does not appear that top management fully understands,
monitors, or manages the risk associated with the new investments. Because of this lack of
Fraud Focus: Contemporary and Historical Cases
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a.
Inherent risks:
• Weak regulatory oversight
• The company used paper copies for bank statements, and the auditor or regulators did not
require electronic confirmation
Fraud risks:
• The CEO had a very lavish lifestyle
Control risks:
• Unusually intense CEO involvement in the cash account
b. Oversight was relatively weak, particularly in terms of the confirmation process. The fact
that NFA did not follow up on customer complaints and an anonymous tip directly related to the
fraud is troubling.
c. It is not necessarily problematic that Wasendorf served in an advisory role to NFA. The
agency likely thought that he was a leader with subject-matter expertise and that he would help
entity. This case bears a strong similarity in this regard to the Madoff fraud and the one-person
auditing firm used in that case. There is nothing incorrect about receiving a paper copy of the
e.
A Framework for Ethical Decision Making
Wasendorf and bank employees.
Step 1.
Step 2.
Determine the affected parties and identify their rights.
US Bank. Has a right to conduct its business within the laws of the United States; and has
a right to act in a way that makes their customers (Wasendorf) happy.
Step 3.
Determine the most important rights.
Step 4.
Develop alternative courses of action.
a. US Bank could do nothing, which is the course of action that they actually took.
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Step 5.
Determine the likely consequences of each proposed course of action.
a. The consequences are that US Bank may face action from the individuals that lost money
in the fraud.
Step 6.
Assess the possible consequences, including an estimation of the greatest good for the
greatest number. Determine whether the rights framework would cause any course of
action to be eliminated.
a. This option should be eliminated because it does not address the problem in any way.
Step 7.
Decide on the appropriate course of action. Representatives at US Bank should have
realized that something was strange in the control environment at PFG given the highly
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a. The quote by Raju received a lot of media attention at the time, as one might imagine. It
probably speaks to the incredible stress that he was under trying to manage, maintain, and hide a
growing fraud that he had been perpetrating for years. It illustrates the emotional difficulty and
b. The fundamental flaw was that the auditors relied on management to physically control
PwC was earning very high audit fees, and Satyam was a seemingly profitable, high-profile
client. There would certainly been incentives for the auditors to not annoy or stand up to the
client, thereby limiting the professional skepticism with regard to the confirmation process.
There was also speculation, backed up to a large extent by the fact that the PwC partners were
arrested, that they were a willing part of the fraud, the worst possible violation of skepticism
possible.
c. The existence or occurrence assertion was violated.
d. The following controls were violated or did not exist:
e.
Step 1. Identify the ethical issue. As stated in the case so that students get off to the right
start, the ethical issue in this case is how to properly ensure that the review comments are
taken seriously and addressed.
opinion
The PwC reviewing partner: the right (and responsibility) to make sure his or her
comments are addressed
Step 2.
Determine the affected parties and identify their rights.
PwC: the right to conduct an audit without client interference
Step 3.
Step 4.
Develop alternative courses of action.
a. Do nothing, ignoring the fact that the review comments have been unaddressed.
Step 5.
Determine the likely consequences of each proposed course of action.
a. This is likely what happened in the real situation, and of course the consequence was
massive reputation and financial losses for PwC, both in India and the U.S.
Step 6.
Assess the possible consequences, including an estimation of the greatest good for the
greatest number. Determine whether the rights framework would cause any course of
action to be eliminated.
a. Given what we know about the ultimate consequences, this option should have been
eliminated.
Step 7.
Decide on the appropriate course of action.
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a. In cases in which inherent and control risks are low, and the cash balance is immaterial,
relying on client-provided mailing addresses and bank statements is unlikely to lead to
heightened audit risk. However, auditors should use professional judgment and not rely on low-
cost procedures for material line items, even if inherent and control risks are low. In the case of
Parmalat, it seems highly unlikely that $5 billion would have been immaterial. Thus, relying on
a client provided mailing address in that setting seems to be an example of poor audit judgment.
Application Activities
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Answers will vary depending on student discussion. For a good summary with a large number of
practical examples, see The Journal of Accountancy (December 2001 issue) for an article titled
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Answers will vary depending on the timing of when this question is completed, but should make
for lively classroom discussion.
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a. Deloitte and Grant Thornton.
b. The amount sought in recovery was over $10 billion.
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NOTE TO INSTRUCTOR: The response will vary depending on the companies selected and
the time period analyzed. As an example, we present results based on comparing Yahoo and
Google in 2010 and 2011.
FYE 2010 and 2011
Yahoo
Comparison
a. cash trends
Cash has been stable in the
$1.5 billion range for the
last several years.
Both
companies
have ample
cash on hand.
b. interest returns and
investment returns trends
Interest and investment
income were about $23
million and $19 million in
2010 and 2011,
respectively.
Google has a
much larger
amount.
c. analyze cash balances,
and changes therein, in
No new debt has been
issued recently, and the
position.
Google
recently issued
d. current assets/current
liabilities
2010: 4,345,548/1,625,872
= 2.67
2011: 3,452,536/1,207,361
= 2.86
Yahoo is in a
stronger
position in the
current ratio.
e. cash + cash equivalents
2010: (1,526,427 +
2.15
The two
quick ratio.
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2011: 1,323,806/4,984,199
= 0.27
Cash flow to income:
2010: 1,240,190/1,244,628
are both better
at Google.
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Answers to this question will vary depending on the particular findings of the students, but
should make for lively classroom discussion. As examples, we note the following articles, which
the students could find via a Google search:
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a. ISA 505, External confirmations.
b.
1. Exception – A response that indicates a difference between information requested to be
2. External confirmation – Audit evidence obtained as a direct written response to the
3. Negative confirmation request – A request that the confirming party respond directly to
5. Positive confirmation request – A request that the confirming party respond directly to
the auditor indicating whether the confirming party agrees or disagrees with the
information in the request, or providing the requested information.
c. The auditor should inquire as to management’s reasons for the refusal, and seek audit
evidence as to their validity and reasonableness. The auditor should also evaluate the
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implications of management’s refusal on the auditor’s assessment of the relevant risks of
material misstatement, including the risk of fraud, and on the nature, timing and extent of other
audit procedures. Finally, the auditor should perform alternative audit procedures designed to
obtain relevant and reliable audit evidence.
d. The auditor should obtain further audit evidence to resolve any doubts. The factors that
would cause the auditor to doubt reliability include if the auditor receives the confirmation
indirectly, or the confirmation appears not to come from the originally intended confirming
party.
e. The auditor should evaluate the implications on the assessment of relevant risks of
material misstatement, including the risk of fraud, and on the related nature, timing, and extent of
other audit procedures.
f. The auditor should consider the following:
• The assertions being addressed
• Specific identified risks of material misstatement, including fraud risks
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Answers to this question will vary depending on the particular findings of the students, but
should make for lively classroom discussion.
Academic Research Case
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a. Financial statement users have been placing increasing importance on companies’ cash
flow information. This study obtains an understanding of (1) whether companies respond to
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b. The author finds that each of the four incentives identified are associated with inflating
reported CFO. Further, the author finds that the methods used to increase CFO include both
classification choices (at times resulting in restatements) and timing choices (for example,
shorter Q4 cash conversion cycles).
In terms of the method used to inflate CFO, the author finds that when these incentives are
present, firms are more likely to classify cash inflows in the operating section if the choice is at
their discretion (tax benefits from exercise of employee stock options prior to promulgation of
accounting guidance on the topic). However, the author finds that two incentives are not
significantly associated with this classification choice – long-term credit rating near the
investment/non-investment grade cutoff, and a need to meet or beat analysts’ forecasts.
In terms of findings related to management timing of cash flows, the author examines the cash
conversion cycle, which measures how long it takes a firm to collect cash on accounts receivable
after the firm pays cash for its inventory. In the fourth quarter (Q4), managers have an
opportunity to delay payments and accelerate receipts, thereby increasing CFO. A short
c. First and foremost, the attention surrounding cash flow information is escalating.
Analysts and managers are issuing an increasing number of cash flow forecasts, and market
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d. To test the relationship between the identified incentives and upward management of
CFO, the author develops a sample of companies with publicly available data from 1998-2008.
However, companies in regulated industries, and banks and financial institutions are not included
To understand if classification choices are employed as a manipulation method in response to
incentives, the author first obtains a sample consisting of 414 firm years of cash flow
restatements and a matched sample of firms without cash flow restatements. The author then
uses logistic regression to test the relationship between a restated cash flow statement (the
dependent variable) and the incentive factors (the independent variables)
The next classification test considers how firms classified a particular item, when given
discretion as to their choice. Prior to the mandatory expense of stock options, no guidance was
provided as to where the tax benefit from the exercise of employee stock options should be
classified. The author obtained a sample of firms from 1994 (when data is first available) to 2000
The timing test examines differences in the length of the last quarter’s cash conversion cycle
compared to the other quarters. If firms are delaying payments and accelerating collections
before the financial statement cutoff date (as a final effort to boost CFO), Q4’s cash conversion
e. This study has a number of limitations. First, the author uses an approach to determining
unexpected CFO from prior literature. This approach requires that firms have data available for a
ten year period, creating a natural bias towards more mature, stable firms. Further, it may be the
case that the approach for determining unexpected CFO may not have successfully captured all
Ford and Toyota
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Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and Toyota