2.108 In identifying risks of material misstatement due to fraud, it is help-ful for the auditor to consider the information that has been gathered in accor-dance with the requirements of AU section 316.19–.34i. The auditor's identi-fication of fraud risks may be influenced by characteristics such as the size, complexity, and ownership attributes of the entity. In addition, the auditor should evaluate whether identified risks of material misstatement due to fraud can be related to specific financial-statement account balances or classes of transactions and related assertions, or whether they relate more pervasively to the financial statements as a whole. Certain accounts, classes of transactions, and assertions that have high inherent risk because they involve a high degree of management judgment and subjectivity also may present risks of material misstatement due to fraud because they are susceptible to manipulation by management.
2.109 Although, due to daily valuation requirements, there are only a few areas in investment companies' financial statements that require significant judgment, the fact that significant amounts of investments are valued by man-agement, either judgmentally or through valuation models, presents a number of risks that need to be addressed by the auditor. The following risk factors related to fair valuation of investments should be considered:
a. Lack of approval and/or oversight of fair valuation policy by the board of directors
b. Lack of specificity in fair valuation policy and procedures c. Lack of consistency in application of valuation procedures
d. Inordinate influence of portfolio management personnel over fair valuation decisions
e. Apparent fair valuation when market values may be readily avail-able
f. Lack of monitoring/follow-up of fair valuation actions taken
bSee footnote b in paragraph 2.99.
iParagraphs .19 through .34 of AU section 316 can be found in AICPAProfessional Standards andPCAOB Standards and Related Rules.
g. Lack of evidence for fair valuation decisions made
h. Significant amounts of investments traded in "thin" markets, par-ticularly through one market maker (either exclusively or primar-ily)
i. For securities not traded in organized markets (in particular, pri-vate placements) determination of whether a purchase of invest-ments has occurred requiring the initiation of valuation procedures, or whether a sale has occurred for recognition of realized gain/loss j. Increases in the value of investments valued by management shortly after their acquisition without adequate explanation of cir-cumstances
2.110 In addition to fair valuation, risks are present in daily market valu-ation as well. Risks to be considered include:
a. Use of a pricing service with inadequate capabilities or controls b. Ability of portfolio management or other unauthorized individuals
to override prices
c. Lack of consideration of or availability of secondary/comparative pricing sources
d. Significant levels of pricing from brokers e. Manual entry or override of prices
2.111 Derivative instruments are another class of transactions character-ized by high inherent risk. The following risk factors should be considered for derivatives:
a. Lack of policy governing derivative investments, including a clear definition of derivatives
b. Lack of oversight over the use of derivative investments, including ongoing risk assessment of derivative instruments
c. Lack of adequate procedures to value derivatives
d. Lack of awareness or understanding of derivative transactions on the part of senior management or the board of directors
2.112 Trading of investment securities also poses some risks, including the following factors:
a. Lack of segregation of duties between portfolio management and trading functions
b. Lack of developed and consistently applied and enforced trade al-location policy
c. Trading through unapproved counterparties
d. Lack of enforcement of personal trading (code of ethics) policy e. Lack of monitoring of commission levels and volume of trading by
broker
2.113 The following factors should be considered for transfer agency/
capital stock activity:
a. High volume of cancel/rebook or "as-of " activity b. Credible shareholder complaints
c. Activity on dormant accounts
d. Inadequate segregation of duties among mail processing, transac-tion processing, and reconciliatransac-tion functransac-tions
e. Inadequate segregation of duties within transaction processing, such as allowing processors to change address or banking instruc-tions and initiate a redemption
2.114 Other areas that need to be considered because they involve a high degree of management judgment and subjectivity and are susceptible to ma-nipulation by management include the following:
a. Income recognition on high-yield debt instruments where col-lectibility is in question, or on asset-backed securities requiring significant estimates as to the timing of expected cash flows b. Major judgments made in determining that a regulated investment
company has qualified for pass-through status under Subchapter M of the Internal Revenue Code, which may include determining
"issuers" for diversification status, major determinations of classi-fication of revenue items as ordinary income or (long-term) realized gain, and satisfaction of minimum distribution requirement c. Significant elements of incentive fee computations (including
com-putation of any benchmarks against which performance is to be measured)
A Presumption That Improper Revenue Recognition Is a Fraud Risk 2.115 Material misstatements due to fraudulent financial reporting often result from an overstatement of revenues (for example, through premature revenue recognition or recording fictitious revenues) or an understatement of revenues (for example, through improperly shifting revenues to a later period).
Therefore, the auditor should ordinarily presume that there is a risk of material misstatement due to fraud relating to revenue recognition (See AU section 316.41j).
2.116 The risk of material misstatement of an investment company's finan-cial statements due to improper revenue recognition will often be considered inherently low. For securities traded on active markets valuations can be read-ily established, interest on fixed-income securities can be readread-ily computed as the product of coupon rate and par value while dividend income can be readily determined through use of widely-available reporting sources. The more a par-ticular fund departs from this model, the greater the risk of material misstate-ment due to fraud relating to revenue recognition. For example, as discussed above, revenue recognition on certain asset-backed securities depends heavily on management's estimation of future cash flows, and management must es-timate collectibility of interest (including unamortized discount) on high-yield securities where the underlying issuer is evidencing financial difficulty.
2.117 Various risks exist to the extent that securities cannot be valued on the basis of prices determined on an active market:
•
To the extent that management is estimating the value of port-folio investments, even through generally recognized models, the risk of fraudulent misstatement through systematic bias ordinar-ily exists.jParagraph .41 of AU section 316 can be found in AICPAProfessional Standards and PCAOB Standards and Related Rules.
•
If an investment is valued through a single market maker (often the counterparty that sold the investment to the investment com-pany), there is a risk that collusion occurred between that market maker and management in establishing a valuation for the invest-ment.•
In many cases independent valuation services provide estimates of value for fixed-income securities based on observable market transactions and financial information (including security ratings) available publicly. In some cases, however, the independent valu-ation service estimates value for securities that are not traded in the market, and for which the investment company may be the pre-dominant, or sole, holder of the securities, based predominantly, or solely, on information that is provided by the investment com-pany. In these infrequent cases, there is a risk that the information provided by management to the service is incomplete or otherwise biased.•
If the market for a security is "thin," there is a risk that the in-vestment company (or related inin-vestment companies) may be able to manipulate the quoted price by systematic purchases of the security in the market. An auditor would not ordinarily be ex-pected to identify price manipulation, but may be able to identify a "thin" market, in which trades are typically sporadic, so that small changes in supply or demand can have a significant effect on quoted prices. Usually, such securities only have an extremely small "float" (i.e., freely tradable amounts owned by the public).2.118 The following factors need to be considered related to recognition of interest and dividend revenues:
•
Cash receipts for interest or dividend payments are significantly different from accrued amounts.•
Receivable balances include potentially uncollectible interest or dividends, such as significantly overdue amounts.•
Interest or dividend accrual policies do not comply with GAAP or are not enforced.•
Daily interest income is erratic rather than reasonably consistent.•
Procedures in place to identify dividends earned are lax.•
Interest or dividends receivable may be written off without inde-pendent approval.2.119 The following factors need to be considered with respect to revenue recognition for realized and unrealized gains:
•
Stated policy for purchase lot selection on security sales is not followed.•
Realized gains are not properly calculated on sales.2.120 The auditor also needs to ensure that an investment company does not record capital contributions from affiliates as revenues (see paragraphs 7.56 through 7.58 for guidance on the accounting for payments by affiliates and corrections of investment restriction violations).
A Consideration of the Risk of Management Override of Controls 2.121 Even if specific risks of material misstatement due to fraud are not identified by the auditor, there is a possibility that management override of controls could occur, and accordingly, the auditor should address that risk (see AU section 316.57k) apart from any conclusions regarding the existence of more specifically identifiable risks. Specifically, the procedures described in AU sec-tion 316.58–.67lshould be performed to further address the risk of management override of controls. These procedures include (1) examining journal entries and other adjustments for evidence of possible material misstatement due to fraud, (2) reviewing accounting estimates for biases that could result in material mis-statement due to fraud, and (3) evaluating the business rationale for significant unusual transactions.
Key Estimates
2.122 The financial statements of investment companies are typically less complicated than those of other enterprises and have relatively few estimates.
Most key estimates relate to revenue recognition, including portfolio valuation, as well as interest recognition on high-yield and asset-backed securities, which are discussed in paragraphs 2.114, 2.116, and 2.117. Material expense accru-als (in particular, performance fees) and estimates of shareholder activity for previous day pricing clients can also require significant estimation procedures.
2.123 Often, non-accounting estimates are integral to measuring a portfo-lio's compliance with its investment objective and characteristics (for example, the "duration" of a fixed-income portfolio often is a key characteristic, and esti-mates are required to measure the duration of asset-backed and other securities subject to prepayment). While these non-accounting measures typically are not explicitly tested in an audit of financial statements, the auditor should be aware of their existence and consider how their use is controlled by management.