INVESTMENT SECURITIES PAGE 1 05-03 I. OBJECTIVES 1. To determine if policies, procedures, practices, and internal controls regarding investments are adequate; that officers/employees are operating in accordance with established guidelines. 2. To ensure transactions are properly authorized, recorded, and executed at current market prices; that securities, as recorded, are on hand or in possession of custodians for the bank's account. 3. To determine that subsidiary records are reconciled on a regular basis and are in agreement with G/L control accounts. 4. To determine that accrual of income, amortization of premiums, and accretion of discounts are appropriate and accurate. 5. To determine compliance with laws, rulings, and regulations. II. PLANNING 1. Complete Section I of the Audit Planning and Review Guide. III. PRELIMINARY REVIEW 1. Request appropriate person(s) to complete, sign and return, the Internal Control Questionnaire. 2. Obtain copies of investment policies and procedures. Review for potential control, and/or operational weaknesses. Basic investment policy objectives should include the following: Guidelines on the quality and quantity of each type of security to be held, with the stipulation that securities acquired will be eligible and in amounts conform- ing to the limitations prescribed by 12 USC 24 (7) and 23 CFR 1; A program for obtaining and evaluating current credit information on securities in the portfolio, including credit analysis /reviews prior to purchase and periodic credit updates; Risks diversification, i.e., credit risk, interest rate risk, and market risk, associ- ated with concentrations in holdings; Generating a favorable return on investments; A well defined maximum allowable maturity program in meeting liquidity requirements; Meeting pledging requirements. 3. Determine policies/procedures reflect FASB-115, "Accounting for Certain Investments in Debt and Equity Securities", (effective 1/1/94), including; Classification of investments into 3 categories, i.e., Available-for-Sale (AFS), Held-to-Maturity (HTM), and Trading Account; Description of accounting requirements; Pricing and periodic evaluation; Disclosures for sales and transfers. 4. Supplement review of policy and procedures with control reviews /interviews with Investment Officer and other personnel, as appropriate. Document/update permanent file for the following: INVESTMENT SECURITIES PAGE 2 05-03 Discuss/describe risk diversification associated with concentrations in holdings, in the portfolio, and how controlled /managed; Discuss/describe investments maturity program in meeting the bank's liquidity requirements, i.e., anticipated loan increases, deposit decreases, and unexpected liquidity demands; Discuss/describe Investment Committee and BOD approvals, if and when required, under what circumstances (obtain copies for PF); Discuss/describe selection and approval of securities dealers and determine whether the BOD or Committee has reviewed/approved a list of securities firms (obtain copy for PF) with whom the bank is authorized to do business. The dealer selection process should include: ability to fulfill commitments, as evidenced by capital strength and operating results disclosed in current financial data; general reputation for financial stability; inquiry/knowledge of any enforcement actions against the dealer, affiliates, or associated personnel; inquiry, as appropriate, into the background of the sales representative to determine experience and expertise;Discuss/describe securities trading activities, to what extent, if and when allowed; Discuss/describe securities lending activities, to what extent, if and when allowed; Discuss/describe overall impact of FASB-115 on the bank's investment strategy and efforts to comply with its requirements, including: the process used in determining the quality and quantity/amount of the types securities placed in each investment category; actual or perceived impact to the bank's balance sheet brought about by the accounting changes (good, bad, or indifferent); Inquire of the Investment Officer whether off-balance sheet derivative products, i.e., interest rate swaps, futures contracts, etc., are utilized in the investment decision making processes. If so, determine that: derivatives activity is conducted under close Management and BOD supervision; valuation of derivatives and positions in determining the risks in- volved; policies/procedures governing these activities are detailed including, prohibition on the use of leveraged and complex derivatives with limitations on the total amount of derivative contracts that may be outstanding at any time. Note: Derivative products are used by financial institutions to improve its balance between interest-sensitive assets and interest-sensitive liabilities in managing interest rate sensitivity, while continuing to meet the credit and deposit needs of its customers. Properly managed, the use of non-complex, non-leveraged derivative products can reduce the potential negative impact on net interest income in a rising interest rate environment. 5. Based upon review of the ICQ and this preliminary review, conclude on the adequacy, effectiveness, and efficiency of the internal control systems over investment securities operations /functions. 6. Document any significant weaknesses in the General Binder, Section GB-6, Possible Report Comments. Also, identify audit priorities and consider the need to adjust procedures. IV. AUDIT STEPS Balancing 1. Obtain subsystem reports and reconcilements for all investment accounts, related income/expense accounts, and any suspense/clearing accounts, as of our audit date; INVESTMENT SECURITIES PAGE 3 05-03 Foot reconcilements and verify mathematical accuracy; Trace subsystem totals from reconcilement to supporting subsystem reports; Trace G/L totals from the reconcilement to the Daily Balance Sheet; Trace all reconciling items to clearance and investigate any old and unusual items. 2. Determine the bank's subscription of Federal Reserve Stock equals 6% of the bank's capital and surplus, of which, 3% must be paid in. Recalculate dividend income and trace to G/L. Confirmations 3. Prepare and mail confirmation requests for securities held in safekeeping by correspondent banks and other custodians, as of audit date; Compare securities safekeeping lists received from the correspondents/agents to the bank's securities inventory report; Determine pledge status is properly noted; Investigate and clear all exceptions; Send second requests to safekeeping agents from whom no reply was received. 4. Examine/count any securities on hand and compare details to the securities inventory report; Account for all bond coupons, if any; Investigate any discrepancies. Tests of Security Transactions 5. Select a sample of investments purchased, since the previous audit, and perform the following: Verify cost by examining invoices/advices; Trace purchases to entries in the G/L; Trace purchase transactions to approval in the Investment Committee or BOD minutes. 6. For securities sold, verify that gains or losses were accurately computed and recorded; Verify sales price by examining invoices and broker's advices; Check computation of book value on settlement date; Calculate gain or loss and trace to G/L; Verify G/L has been properly relieved of the investment, accrued interest, premium, discount, and any other related accounts; Trace sales transactions to approval in the Investment Committee or BOD minutes. Premium Amortization/Discount Accretion 7. For investments purchased at a premium or discount, since the previous audit, select a sample and test book value, by performing the following: Determine method used to calculate and record amortization of premiums and accretion of discounts; and INVESTMENT SECURITIES PAGE 4 05-03 Determine the gross amount of premium or discount at purchase date; Determine period to maturity or call date; Calculate the amount of premium or discount remaining to be amortized or accreted; Determine that book value is properly reflected in the general ledger; Investigate any discrepancies. Accrued Interest 8. Determine the bank's method of calculating and recording interest accruals. Using the sample selected in Step 7, test accrued interest: Obtain trial balance of accrued interest, if maintained separately, from trial balance of investments and; Determine interest rate and last interest payment date; Calculate accrued interest and compare to the trial balance; Investigate any significant discrepancies. 9. Prepare, a schedule, for each kind of investment, showing accrued interest balance and investment balance at each quarter end, since last audit: Calculate the ratios of accrued interest to investment balance for each type and time period; Investigate significant fluctuations/trends. Other 10. Review the bank's compliance with FASB-115, "Accounting for Certain Investments in Debt and Equity Securities". Note: FASB-115 places many restrictions on the sales /transfers of Held-to-Maturity (HTM) securities and such transactions are expected to be unusual and rare. Review all sales/transfers out of the HTM category, since previous audit, and verify that: o Sufficient documentation exists outlining intent /circumstances leading to decision; o Reasons comply with FASB-115 requirements for changes in circum- stances; o The BOD, as noted in the minutes approves such transactions. Determine whether portfolio classifications are periodically re-assessed for appropriateness (quarterly); Those adjustments, as applicable, are properly recorded on the bank's books. 11. Review the bank's compliance with OCC's Investment Securities Regulation (12CFR1).
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