Auditing Investments - ACUIA

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					Auditing Investments
 Firley, Moran, Freer & Eassa, P.C.
Firley, Moran, Freer & Eassa, P.C. is a CPA firm located in Syracuse, New
York and provides audit and assurance services, tax services, regulatory
compliance, business consulting and other financial-focused business
services. We provide a wide rage of services to over 20 credit unions
ranging from $28mm to over $1 billion in assets. We rank as the second
largest CPA firm in Central New York according to the CNY Business
Journal’s Book of Lists and currently employ over 75 people including 55
CPAs licensed in New York and various other states nationally.

We are also a member of the McGladrey Alliance which provides us with
unique access to “national firm” technical support, continuing education
and practice management assistance, while allowing us to retain our local
office ownership and autonomy. McGladrey is the fifth largest accounting
and consulting firm in the United States and is one of the leading credit
union service providers in the country.
                           Auditing Investments
Mark Colombo, CPA              mcolombo@fmfecpa.com          James Flynn, CPA                     jflynn@fmfecpa.com
Mark is a Principal with Firley Moran, Freer & Eassa, P.C.   Jim is a Senior Manager with Firley, Moran, Freer &
and is a Certified Public Accountant with 19 years of        Eassa, P.C. and is a Certified Public Accountant with 18
public accounting experience providing auditing,             years of public accounting experience providing auditing,
accounting and tax services to clients. Mark’s client        accounting, consulting, tax and forensic services to
service experience primarily includes credit unions and      clients. Four of his 14 years of public accounting
credit union service organizations.        Mark has an       experience were with PricewaterhouseCoopers (formerly
extensive background in providing auditing, accounting,      Coopers & Lybrand), where he had a concentration in
tax and regulatory compliance services, and internal         financial institutions and insurance. He currently serves
control evaluations to credit unions. Mark manages           clients in the credit union, group self-insurance and
various projects for thirteen credit union clients ranging   construction industries, including a specialization in
in asset size from $26 million to over a billion dollars.    auditing employee benefit plans. Jim has been involved
Mark also heads the firm’s internal audit co-sourcing and    with the credit union movement since college when he
regulatory compliance engagements. He has designed           worked as a teller at a local credit union. He currently
internal audit programs, assisted in creating internal       performs services for eight of our credit union clients
audit departments and oversees the internal audit and        ranging in size from $90 million to over $1 billion in
compliance work.                                             assets.

Mark holds a position as Treasurer on the Board of           Jim is a member of the ACUIA, AICPA and the NYSSCPAs,
Directors of the Central New York March of Dimes and is      holds a Bachelor of Science degree, with distinction,
a Director on the Board of the Fairmount Community           from Clarkson University and serves his community as
Library. Mark received his Bachelor of Science degree        the fire chief of a local volunteer fire company.
from LeMoyne College and is currently a member of the
ACUIA, AICPA and the NYSSCPAs.
                    Overview of Content
1. Common Credit Union Investments
    –   Certificates of Deposit
    –   US Treasury Bonds and Notes
    –   US Government Agency Bonds
    –   Mortgage Backed Securities
    –   Collateralized Mortgage Obligations
    –   FHLB Stock
    –   Credit Union Service Organization (CUSO)

2. Financial Statement Disclosures Related to Investments
    – FASB ASC 820, “Fair Value Measurements” (formerly SFAS 157)
    – FASB ASC 320, “Investments – Debt and Equity Securities” (formerly SFAS 115)

3. Walkthrough of Significant Processes
    – Walkthrough Assertions
          Overview of Content (cont’d)
4. External Audit Procedures
   – Testing of the Internal Control Environment
   – Substantive Audit Procedures
       • Debt and Equity Securities
       • Investments in Closely Held Corporations, Partnerships or Joint Ventures
       • Derivatives
       • Interest Income
       • Accrued Interest Receivable
       • Disclosures
       • Concluding Steps
      Common Credit Union Investments
1. Certificates of Deposit
     – Brokered
     – Direct
2. US Treasury Bonds and Notes
3. US Government Agency Bonds
    – FHLB
    – FHLMC
    – FNMA
    – GNMA
    – Etc.
4. Mortgage Backed Securities
    – Participations in (i.e. actual ownership of) organized pools of residential mortgages, the
       principal and interest payments on which are passed from the mortgage originators
       through intermediaries (usually quasi-governmental agencies) that pool and repackage
       them in the form of securities, to investors. Such quasi-governmental agencies, which
       guarantee the payment of principal and interest to investors, include GNMA, FNMA,
       RTCMA, and others.
 Common Credit Union Investments (cont’d)
5. Collateralized Mortgage Obligations
    – An instrument generally issued by a special-purpose vehicle (SPV) collateralized by a pool of
      mortgages. The SPV may be legally organized as a trust, corporation, or partnership and may
      issue CMO instruments in equity or non-equity form. The SPV purchases a group of mortgages
      using the proceeds of an offering collateralized by the mortgages. The SPV uses the
      underlying cash flows of the collateral to fund the return on the instruments required by
      investors. The instruments are priced based on their own maturity and rate of return rather
      than that of the underlying mortgages.

6. FHLB Stock
    –    Cost method investment in stock

7. CUSOs
    – Wholly owned by the Credit Union or owned by multiple credit unions.
         •   C-Corporation
         •   Limited Liability Company (LLC) or Partnership
    – CUSOs engage in one or more of many types of services, such as; income tax return
      preparation, personal investment services, insurance, shared branching, etc.
Financial Statement Disclosures Related to
               Investments
• FASB ASC 820, “Fair Value
  Measurements”
  (formerly SFAS 157)
   – Level 1 - quoted prices in
     active markets for identical
     inputs
   – Level 2 - other significant
     observable inputs
   – Level 3 - significant
     unobservable inputs
     (including the Credit
     Union’s own assumptions
     in determining fair value)
Financial Statement Disclosures Related to
           Investments (cont’d)
• FASB ASC 320, “Investments – Debt and Equity
  Securities” (formerly SFAS 115)
   – Credit Union’s typically classify investment securities as
     either held to maturity or available for sale.
      • Held to maturity securities are those that the Credit Union has the
        positive intent and ability to hold to maturity, and are reported at
        cost, adjusted for amortization of premiums and accretion of
        discounts.
      • Investment securities not classified as held to maturity are
        classified as available for sale and are reported at fair value, with
        net unrealized holding gains and losses reflected as a separate
        component of members’ equity.
      • Trading securities are reported at fair value but are typically not
        applicable for Credit Unions. Unrealized gains or losses on the
        trading portfolio are recorded in the income statement.
    Walkthrough of Significant Processes
•   Authorization and Initiation
•   Recording
•   Processing
•   Reporting
•   Safeguarding of Assets
             External Audit Procedures
Test of Controls
   – For each relevant assertion where the planned control risk
     assessment is below the maximum, identify specific controls
     that are designed to prevent or detect and correct on a timely
     basis errors and fraud, which may be individually or
     cumulatively material, in those assertions and determine that
     such controls have been placed in operation.
   – Perform one or more of the following procedures to test the
     operating effectiveness of identified controls during the period
     under audit:
       •   Perform corroborative inquiry
       •   Perform observation procedures
       •   Perform inspection procedures
       •   Perform “re-performance” procedures
    External Audit Procedures (cont’d)
Debt and Equity Securities
   – Obtain an analysis of activity during the period in the securities
     portfolio separated by classification type; trading(if applicable), held-
     to-maturity, or available for sale; and do the following:
       • Trace the opening balances to the adjusted prior-year working trial balance
         and the ending balances to the current-year working trial balance.
       • Review any reconciliation to the general ledger and investigate any unusual
         reconciling items.
   – The following worksheets are recommended:
       •   Investment Rollforward and Analysis
       •   Marketable Equity Securities Information
       •   Investment Interest Accrual Information
       •   Debt Security Amortization Information
       •   Investments in Debt and Equity Securities
    External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
   – Obtain supporting schedules of unamortized premium or un-
     accreated discount and reconcile to schedule(s) of securities and
     derivatives in total.
   – Where applicable, test the propriety of the classification of
     securities as trading, held-to-maturity, or available for sale.
       • Classification of debt and equity securities is based on (1) the type of
         security and (2) management’s ability and intent to hold the
         investment. The classification of debt and equity securities should be
         documented by the Credit Union.
       • Debt securities should not be classified as held-to-maturity if they will
         be available to be sold in response to changes in the following:
           –   Market interest rates and prepayment risk.
           –   Liquidity demands.
           –   Availability or yield of alternative investments.
           –   Funding sources and terms.
    External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
   – Evaluate management’s intent and
     ability to hold securities classified
     as held to maturity.
   – Determine that debt securities classified as held-to-
     maturity are valued at amortized cost and that debt and
     equity securities classified as trading(if applicable) or
     available-for-sale are valued at fair value.
   – Determine that the unrealized gain or loss on the trading
     portfolio has been properly classified in the income
     statement and that the unrealized gain or loss on the
     available-for-sale portfolio has been properly classified in
     equity.
    External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
   – Determine that any other-than-temporary decline in value of
     securities classified as available-for-sale or held-to-maturity has
     been properly recognized and accounted for.
       • Relevant information to consider:
           – Fair value is significantly below cost.
           – The decline in fair value can be attributed to adverse conditions specifically
             related to the security or to specify industry or geographic conditions.
           – The Credit Union does not have the ability or intent to hold the investment for
             a sufficient time period to allow for any anticipated recovery in fair value.
           – The decline in fair value has existed for an extended period of time.
           – A rating agency has downgraded a debt security’s rating.
           – The financial condition of the security’s issuer has deteriorated.
           – Scheduled interest payments on debt securities have not been made or
             dividends have been reduced or eliminated on equity securities.
           – Losses from the security have been recorded by the Credit Union subsequent
             to period-end.
     External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
    – A security is impaired if the fair
      value of that security is less than its
      amortized cost basis. The following
      relevant information should be
      documented:
         • The magnitude of the impairment
           (i.e. the unrealized loss as a
           percentage of the adjusted cost
           basis).
         • The duration of the impairment (i.e.
           the number of consecutive months
           that the fair value of the security has
           been less than its adjusted cost
           basis).
         • The original (i.e. purchase date)
           ratings of the investment security
           (i.e. Moody’s, S&P, Fitch).
         • The current ratings of the investment
           security.
         • Qualitative information regarding the
           financial condition of the issuer.
   External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
  – Review general ledger activity
    for purchases and sales of
    investment securities recorded
    within 5 business days before and after year end for
    proper cut off.
  – Review investment activity and inquire of
    management about the existence of any repurchase
    agreements, short sales, or wash sales.
   External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
  – Test of Mechanical Accuracy
  – Inspection and Confirmation of
    Securities
     • Inspect the original certificates of securities on hand
       and confirm securities held by others.
                • Document the items selected for confirmation.
                • When inspecting securities, it is important not to be
                  left alone with the securities.
   External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
  – Purchase Testing:
     • Vouch the cost of significant purchases of securities
       during the period of examining brokers’ advices and
       other relevant documentation.
        – Transactions should be recorded on the trade date rather than
          the settlement date.
  – Test of Sales Transactions:
     • Vouch the proceeds from significant security sales
       during the period by examining brokers’ advances and
       other relevant documentation.
   External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
  – Test of Income:
     • Analyze the rates of return on major classes of securities (on
       a month-to-month or quarterly basis, if more meaningful to
       do so) and compare with those of prior periods, budgets, or
       other expectations. Obtain explanations for any unusual
       variations.
     • Test investment income by means such as the following:
         – Vouch dividends and interest received.
         – Inspect published sources of dividends and interest income.
         – Recalculate investment income based on balances, rates, and
           time elapsed, and investigate significant differences between the
           calculated and recorded amounts.
   External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
  – Test of Classifications:
     • Test the propriety of the classification of securities as
       trading(if applicable), held-to-maturity, or available for
       sale.
        – Examine documentation of management’s intent such as the
          following in considering the propriety of classification:
            » Written and approved records of investment strategies.
            » Records of investment activities.
            » Instructions to investment managers.
            » Board of directors’/Asset Liability Committee minutes.
   External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
  – Test of Unrealized Gains and Losses and Carrying
    Values:
     • Re-compute the unrealized gain or loss for each security
       classification.
     • For fair value measurements identified by management as
       Level 1 measurements:
        – Compare the market values for a sample of securities with readily
          determinable fair values (sales prices or bid and ask quotations
          are currently available on a securities exchange or in over-the-
          counter markets that are publicly reported by NASDAQ or the
          National Quotation Bureau to financial publications (such as the
          Wall Street Journal) or to internet based pricing sources (such as
          Yahoo) known to be reliable), or confirmed with a registered
          broker-dealer or investment adviser.
   External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
  – Test of Unrealized Gains and Losses and Carrying
    Values (cont’d):
     • Based on the understanding of the Credit Union’s
       investment portfolio and valuation methodology, determine
       if fair value of securities with Level 2 and Level 3
       measurements will be tested directly or through the use of
       an independent estimate.
     • For fair value measurements identified by management as
       Level 2 measurements:
        – Identify the source(s) of the inputs and verify that those inputs
          are observable
        – Consider whether adjustments to Level 2 inputs might render the
          fair value to be a Level 3 measurement.
   External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
  – Test of Unrealized Gains and Losses and Carrying
    Values (cont’d):
     • If fair value of securities with Level 2 and Level 3
       measurements will be tested directly, test management’s
       significant assumptions, the valuation model, and the
       underlying data.
     • If developing an independent estimate to test fair value for
       level 2 or level 3 measurements:
         – Review the understanding of management’s valuation model and
           significant assumptions.
         – Develop independent estimate of fair value.
    External Audit Procedures (cont’d)
Debt and Equity Securities (cont’d)
   – Test of Unrealized Gains and Losses
     and Carrying Values (cont’d):
      • Consider whether events and
        transactions occurring subsequent to
        the balance sheet date should be
        considered as audit evidence
        corroborating or drawing into
        question the relevant fair value
        measurement.
      • Compare the sales price to fair values
        recorded at year end and determine
        whether there is evidence that fair
        values at year end were overstated.
      • Verify that subsequently sold
        securities were not classified as HTM.
   External Audit Procedures (cont’d)
Investments in Closely Held Corporations, Partnerships,
  or Joint Ventures (CUSOs, FHLB)
   – Confirm the Credit Union’s ownership percentage in its
     investees at the reporting date.
      • Test of Cost Basis
          – Vouch (if not previously vouched) the cost of the Credit Union’s
            ownership interest by inspecting appropriate securities or legal
            documents supporting ownership.

   – Determine the proper method of accounting for the
     investment (cost, equity, or consolidation).
      • Consolidation is required for entities that are controlled other than
        through a majority voting interest (that is, through variable
        interests).
     External Audit Procedures (cont’d)
Investments in Closely Held Corporations, etc. (cont’d)
• For investments accounted for using the cost or equity methods, do the
  following:
    – For investments accounted for using the cost method, compare the
      investment and, if applicable, related earnings balances with prior period
      amounts or other expectations.
    – For investments accounted for using the equity method, review the latest
      financial statements of the investee, make inquiries of management, etc., to
      evaluate the reasonableness of the investment carrying value
    – Determine if there has been any other-than-temporary decline in value of the
      investment.
• Test of Carrying Value
    – Review the latest financial statements of the investee, make inquiries of
      management, etc., to determine whether there has been any other-than-
      temporary decline in value of the investment.
     External Audit Procedures (cont’d)
Investments in Closely Held Corporations, etc. (cont’d)
• Tests of the Equity or Consolidation Method
    – Examine documentation supporting material transactions between the Credit
      Union and an investee accounted for on the equity or consolidation basis to
      determine whether intercompany profits and losses are properly eliminated.
         • Inspect the most recent audited financial statements of the investee to verify the
           carrying value of the investment and the current-year income or loss attributed to the
           investment.
         • Determine that the financial statements of the investee are on the same accounting basis
           as the Credit Union’s and that the fiscal year end of the investee coincides with the Credit
           Union’s.
         • Test the accuracy and completeness of the Credit Union’s entry(ies) to consolidate or to
           record the investment.
    – For the Credit Union's investment(s) in its subsidiary(ies), roll forward account
      activity since the prior year end and agree to Credit Union trial balance. Tie
      out total investment in subsidiary to subsidiary's equity.
      External Audit Procedures (cont’d)
Derivatives (Interest only strips, loan servicing assets, retained portion of loans sold)
•   If considered necessary, update your understanding obtained during planning of
    the Credit Union’s use of derivatives.
     – Retained interest in loans sold
     – Loan servicing assets

•   For derivatives designated as hedging instruments:
     – Determine that the hedged item meets the SFAS No. 133 criteria for designation as a hedge.
     – Review the company’s documentation of the hedging relationship to ensure it meets the
       documentation requirements of SFAS No. 133.
     – Obtain an understanding of the methods used to determine whether the hedge is highly
       effective and to determine the ineffective portion of the hedge. Determine that management
       has assessed the effectiveness of the hedging relationship at inception and whenever financial
       statements are prepared, or at least every three months, noting that the method of assessing
       hedge effectiveness is the same as the criteria prescribed by the documentation prepared at
       the inception of the hedge.
    External Audit Procedures (cont’d)
Derivatives (cont’d)
• Test the valuation of the derivatives at year end.
   – Trace fair values to quoted prices, if available (for example,
     quoted market prices for derivatives listed on national
     exchanges and quoted market prices from broker-dealers who
     are market makers). If quoted market prices are not available,
     perform appropriate tests based on the valuation method used.
   – Test the measurement of the realized and unrealized gain or loss
     for derivative contracts.
   – Determine whether the unrealized gain or loss on the
     instruments has been properly classified.
     External Audit Procedures (cont’d)
Interest Income
• Analyze the rates of return on
  major classes of securities (on a
  month-to-month or quarterly
  basis, if more meaningful to do
  so) and compare with those of
  prior years, current-year budgets,
  or other expectations.
    – Determine whether there are
      dividends or interest that
      should be accrued.
    – Determine whether
      amortization of discounts or
      premiums on bonds should be
      recorded.
    External Audit Procedures (cont’d)
Accrued Interest Receivable
• Perform the following analytical procedures:
   – Compare the balance in accrued interest receivable by type of
     asset or in total with the balances for prior years or other
     expectations.
   – Divide the accrued interest balance for each type of asset or in
     total by the related asset balance and compare that percentage
     to the prior year percentage or other expectations.
   – Investigate any unexpected results.
• Obtain and review a reconciliation of accrued interest
  receivable to the general ledger account balance.
• Perform Tests of Mathematical Accuracy
    External Audit Procedures (cont’d)
Accrued Interest Receivable (cont’d)
• Additional Procedures in Response to Fraud Risk
  Assessment:
   – Perform the following procedures (generally as a response
     to identified fraud risks):
      • Evaluate the legitimacy and financial viability of the custodian
        (including verifying the proper address) with whom investments
        are confirmed.
      • Request confirmation of the following information:
          – All transactions during the period, including purchases, sales, dividend
            and interest collections, interest and other expenses paid.
          – The identity of those authorized to make investment transactions.
          – Where interest and dividends are sent.
    External Audit Procedures (cont’d)
Accrued Interest Receivable (cont’d)
• Additional Procedures in Response to Fraud Risk
  Assessment (cont’d):
   – Obtain and review all contracts, agreements, and other
     documents related to investments, including originals (rather
     than copies) of actual securities certificates, broker’s
     statements, and other applicable documents. Obtain an
     analysis of investment activity directly from executing brokers.
   – Review all investment-related journal entries and trace to
     supporting documents if not already reviewed when performing
     other procedures.
   – Review the accounts at the institution of employees with access
     to securities or authority to purchase or sell securities.

				
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