New Guidance on Auditing Investments

Auditors may need to reasses their policies on ivestment-related management representations.

  • STATEMENT ON AUDITING STANDARDS no. 81, Auditing Investments, updates the auditing literature for recently issued accounting standards related to investments in securities. The SAS offers guidance for auditing the existence, ownership, completeness and valuation assertions for investments.
  • WHEN A THIRD-PARTY CUSTODIAN provides services related to an entitys investments, certain evidentiary issues arise. SAS no. 81 does not specifically address the auditors responsibility for auditing financial statement assertions under such circumstances, but additional guidance is being developed by the AICPA auditing standards board.
  • SAS NO.81 ALSO PROVIDES GUIDANCE for auditing managements intent regarding an investment and an entitys ability to hold a debt security to maturity.
  • SAS NO. 81 DELETES INTERPRETATION NO. 1 of AU section 332 and contains guidance for evaluating other-than-temporary impairment conditions. The SAS makes clear that it is managements responsibility to evaluate whether such a condition exists.
  • THE GUIDANCE IN SAS NO. 81 FOR auditing investments accounted for under the equity method of accounting is largely unchanged from that contained in AU section 332.
GEORGE F. PATTERSON, Jr., CPA, is a partner of Ernst & Young LLP in Los Angeles. A former member of the American Institute of CPAs auditing standards board, he chaired the auditing investments task force.

When auditing an entitys investments, auditors should be aware of applicable accounting guidance. They must be familiar with the rules that apply both to the particular type of entity and to the investments it holds. To provide auditors with guidance on gathering evidence about investments, the American Institute of CPAs auditing standards board (ASB) issued Statement on Auditing Standards no. 81, Auditing Investments. It supersedes AU section 332, "Long-Term Investments," of SAS no. 1, Codification of Auditing Standards and Procedures (see also AICPA Professional Standards, AU section 332). SAS no. 81 updates the auditing literature for recently issued accounting standards that address accounting for investments. It also deletes Interpretation no. 1 of AU section 332, "Evidential Matter for the Carrying Amount of Marketable Securities." The purpose of this article is to explain some of the more significant aspects of SAS no. 81.

SAS no. 81 is a fieldwork standard. It provides guidance about the evidence needed to corroborate assertions related to securities investments. Securities are issued in either debt or equity form. The SAS defines a security by referring to the definitions in Financial Accounting Standards Board Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities. SAS no. 81 also provides guidance on auditing investments accounted for under Accounting Principles Board Opinion no. 18, The Equity Method of Accounting for Investments in Common Stock. While SAS no. 81 does not address derivatives (even though a derivative may be a security), some of the guidance may be helpful when auditing assertions about derivatives.

Exhibit 1: Obtaining Evidence About Existence
Ownership and Completeness, SAS no. 81 lists six procedures for obtaining evidence about an entitys investments. The auditor should perform at least one of these six procedures:
  • Physical inspection.
  • Confirmation with the issuer.
  • Confirmation with the custodian.
  • Confirmation of unsettled transactions with the broker—dealer.
  • Confirmation with the counterparty.
  • Reading executed partnership or similar agreements.

SAS no. 81 recognizes that the procedures an auditor performs to gather evidence about the assertions of existence, ownership and completeness will vary depending on the type of investment and the auditors assessment of audit risk. SAS no. 81 notes, however, that the auditor should include at least one of the six procedures listed in exhibit 1. The pronouncement also reminds auditors to consider the guidance in SAS no. 70, Reports on the Processing of Transactions by Service Organizations, when designing procedures to gather evidence about the existence, ownership and completeness of investments.

Certain evidentiary issues arise when a third-party custodian, such as a bank trust department, provides services related to an entitys investments, including maintaining custody of or investing assets. SAS no. 81 does not specifically address the auditors responsibility for auditing financial statement assertions about the ownership, existence and valuation of financial instruments, commodity contracts and similar instruments when a custodian performs services related to an entitys investments. The ASB decided to address these issues in a separate project. This additional guidance is now being developed by the ASBs ownership, existence and valuation task force.

SAS no. 81 provides guidance to auditors evaluating both managements intent with regard to an investment and the entitys ability to hold a debt security to maturity.

Management intent. An auditor should consider whether investment activities corroborate or conflict with managements stated intent for an investment. The SAS gives examples of pertinent evidence an auditor, when evaluating investment activities, should consider, such as written and approved records of investment strategies, records of investment activities, instructions to portfolio managers and minutes of meetings of the board of directors or the investment committee.

Ability to hold a debt security to maturity. The guidance for auditing ability is similar to that for auditing intent. When management classifies a debt security as held to maturity, the auditor gathers evidence that will either corroborate or conflict with the entitys ability to hold that security until maturity. SAS no. 81 lists several factors auditors should consider when evaluating ability, such as whether existing operating and cash flow projections or forecasts provide relevant information about ability. Auditors are not required to create projections or forecasts if none exist. However, auditors exercising their professional judgment might ask management to prepare such prospective financial information.

Management representations. SAS no. 81 says auditors ordinarily should obtain written representations from management confirming, with respect to held-to-maturity securities, that management has the intent and the entity has the ability to hold such securities to maturity.

Procedures an auditor might perform to obtain evidence about investments carried at cost or fair value—or when the fair value of investments carried at cost is disclosed in the financial statements—are listed in SAS no. 81. Recognizing that the approaches for determining fair value described in generally accepted accounting principles sometimes vary depending on investment type, the SAS says auditors should evaluate whether the determination of fair value is consistent with the approach specified in GAAP. For example, the use of market value quotations as opposed to estimation techniques is required when measuring the fair value of equity securities accounted for under FASB Statement no. 115.

Exhibit 2: Factors Indicating an Other-Than-Temporary Impairment
Here are some examples of factors outlined in SAS no. 81 that may indicate an other-than-temporary impairment condition.
  • Fair value is significantly below cost.
  • The decline in fair value is attributable to specific adverse conditions affecting a particular investment.
  • The decline in fair value is attributable to specific conditions, such as conditions in an industry or in a geographic area.
  • Management does not have both the intent and the ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in fair value.
  • The decline in fair value has existed for an extended period of time.
  • A debt security has been downgraded by a rating agency.
  • The financial condition of the issuer has deteriorated.
  • Dividends have been reduced or eliminated, or scheduled interest payments on debt securities have not been made.

As noted above, SAS no. 81 deletes Interpretation no. 1 of AU section 332. The ASB did this for two reasons.
  1. The interpretation was written in the context of the short-term, long-term—lower of cost or market accounting model for investments superseded by Statement no. 115.
  2. The interpretation contained accounting (preparer) guidance, thereby blurring the distinction between the auditors responsibility for the audit and managements responsibility for the fair presentation of the financial statements.

Managements responsibility to determine whether a decline in fair value is other than temporary is explicitly recognized in SAS no. 81. The auditor evaluates whether management has considered relevant information in determining whether an other-than-temporary impairment exists. SAS no. 81 lists eight factors that may indicate an other-than-temporary impairment condition. (See exhibit 2.) The auditor considers existing conditions, obtains evidence about those conditions and evaluates whether the evidence corroborates or conflicts with managements conclusions about the existence of an other-than-temporary impairment for a particular investment it holds.

Investments accounted for using the equity method. The guidance in SAS no. 81 on investments accounted for using the equity method generally is unchanged from the previous standard (AU section 332).

Transition. SAS no. 81 is effective for audits of financial statements for periods ending on or after December 15, 1997. Early application is permissible.

While the issuance of SAS no. 81 may cause auditors to reassess their policies on management representations related to investments, the statement should not be difficult to implement. It is an evolutionary standard that sets the stage for a broader scope project that will address—in greater detail—issues such as the evidence needed to evaluate assertions related to the fair value of financial instruments and the auditors responsibility for evaluating assertions about investments when a third-party custodian is involved.

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