7.142 AU section 314 establishes standards and provides guidance on ob-taining a sufficient understanding of the entity and its environment, including its internal control. It provides guidance on understanding the components of internal control and explains how an auditor should obtain a sufficient under-standing of internal controls for the purposes of assessing the risks of material misstatement. Paragraph .40 of AU section 314 requires that the auditor should obtain an understanding of the five components of internal control (the control environment, risk assessment, control activities, information and communica-tion, and monitoring), sufficient to assess the risks of material misstatement of the financial statements whether due to error or fraud, and to design the na-ture, timing, and extent of further audit procedures. The auditor should obtain a sufficient understanding by performing risk assessment procedures to eval-uate the design of controls relevant to an audit of financial statements and to determine whether they have been implemented. The auditor should identify and assess the risks of material misstatement at the financial statement level and at the relevant assertion level related to classes of transactions, account balances, and disclosures.
7.143 Effective controls, as they relate to financial reporting of invest-ments in securities, should provide assurance that
a. management's policies are adequate to provide for financial report-ing in accordance with GAAP;
b. physical securities are on hand or held in custody or safekeeping by others in accordance with management's authorization;
c. misstatements caused by error or fraud in the processing of ac-counting information for investments in securities are prevented or detected, and corrected in a timely manner;
d. securities are monitored on an ongoing basis to determine whether recorded financial statement amounts necessitate adjustment; and e. the presentation and disclosure of the fair value measurements of
investment securities are in accordance with GAAP.
7.144 Control activities that would contribute to internal control over fi-nancial reporting in this area include the maintenance of management policies, adopted by the those charged with governance or its investment committee, that establish authority and responsibility for investments in securities.
7.145 Other control activities that contribute to strong internal control over financial reporting of securities include the following:
•
Procedures exist to identify and monitor credit risk, prepayment risk, and impairment.AAG-DEP 7.145
164
Depository and Lending Institutions•
Those charged with governance—generally through an invest-ment committee—oversee manageinvest-ment's securities activities.•
Accounting entries supporting securities transactions are period-ically reviewed by supervisory personnel to ensure that classifica-tion of securities was made and documented at acquisiclassifica-tion (and date of transfer, if applicable) and is in accordance with the insti-tution's investment policy and management's intent.•
Recorded securities are periodically reviewed and compared to safekeeping ledgers and custodial confirmations, on a timely basis, including immediate and thorough investigation and resolution of differences and appropriate supervisory review and approval of completed reconciliations.•
Current fair values of securities are determined in accordance with GAAP and reviewed on a timely basis.•
Securities loaned to other entities or pledged as collateral are des-ignated as such in the accounting records.•
Lists of authorized signers are reviewed and updated periodi-cally, and transaction documentation is compared to the autho-rized lists.•
There is appropriate segregation of duties among those who (a) ex-ecute securities transactions, (b) approve securities transactions, (c) have access to securities, and (d) post or reconcile related ac-counting records.•
Buy and sell orders are routinely compared to brokers' advices.•
Adjustments to securities accounts (for example, to recognize im-pairments) are reviewed and approved by the officials designated in management's policy.•
Periodic tests of interest and dividend income are performed by ref-erence to supporting documentation, which may include using an-alytical procedures commonly referred to as yield analysis. (With this approach, actual yields during the period are compared to ex-pected yields based on previous results and current market trends.Any significant differences should be investigated and explained.)
•
Securities are monitored on an ongoing basis and factors affect-ing income recognition and the carryaffect-ing amount of the securities are analyzed periodically to determine whether adjustments are necessary.7.146 The auditor should obtain an understanding of the institution's process for determining fair value measurements and disclosures and of the relevant controls sufficient to develop an effective audit approach, as stated in paragraph .09 of AU section 328, Auditing Fair Value Measurements and Disclosures (AICPA, Professional Standards, vol. 1). See paragraph .12 of AU section 328 for further considerations.
7.147 Many of the control activities for securities are often performed directly by senior management. Although management's close attention to se-curities transactions can be an effective factor in internal control, the auditor should address the risk of management override of policies and procedures during an engagement.
AAG-DEP 7.146
Investments in Debt and Equity Securities
165
7.148 The auditor should perform tests of controls when the auditor's risk assessment includes an expectation of the operating effectiveness of controls or when substantive procedures alone do not provide sufficient appropriate audit evidence at the relevant assertion level. Examples of tests of controls that might be considered include
•
reading minutes of meetings of the board of directors (and any investment committee) for evidence of the board's periodic review of securities activities made so that the board may determine ad-herence to the institution's policy;•
comparing securities transactions, including transfers, to the in-stitution's accounting policy to determine whether the institution is following its policy. For example, the independent accountant may include— testing that transactions have been executed in accor-dance with authorizations specified in the investment policy;
— evaluating evidence that securities portfolios and related transactions (including impairments) are being moni-tored on a timely basis and reading supporting documen-tation; and
— testing recorded purchases of securities, including that classification of the securities and prices and entries used to record related amounts (for example, use of trade ver-sus settlement date, and treatment of commissions, pre-miums and discounts).
•
recalculating a sample of premium and discount amortization amounts and gains and losses on sales;•
reviewing controls over accumulating information necessary for financial statement disclosures;•
testing the reconciliation process. The independent accountant might test whether reconciling differences are investigated and resolved and whether the reconciliations are reviewed and ap-proved by supervisory personnel; and•
examine evidence that the company takes physical inventory and confirms safekeeping on a periodic basis, including reconciliation of differences.7.149 Many financial institutions outsource the determination of fair value measurements of investment securities to third party service organiza-tions, such as a pricing service. AU section 324, Service Organizations (AICPA, Professional Standards, vol. 1), provides guidance on the factors an auditor should consider when auditing the financial statements of an entity that uses a service organization to process certain transactions. The auditor may also consider the following:
•
Whether the pricing service determines fair value measurements in accordance with the requirements of FASB ASC 820.•
If trades of identical securities in an active market are available, is the pricing service's fair value estimates equal to quoted market prices.AAG-DEP 7.149
166
Depository and Lending Institutions•
For trades of identical securities, does the third party pricing ser-vice evaluate whether or not the market is active.•
What is the criteria used to evaluate whether the market is active.•
When a model is used to determine fair value, does the pricing service maximize the use of observable inputs and minimize the use of unobservable inputs.Substantive Tests
7.150 Regardless of the assessed risks of material misstatement, the audi-tor should design and perform substantive procedures for all relevant assertions related to investments in debt and equity securities.
7.151 AU section 332 provides guidance to auditors in planning and per-forming further audit procedures for relevant assertions related to investments in securities, as well as derivative instruments and hedging activities. Chapter 7, "Performing Audit Procedures In Response to Assessed Risks," of the AICPA Audit Guide Auditing Derivative Instruments, Hedging Activities, and Invest-ments in Securities, provides detailed guidance and recommendations about designing and performing substantive procedures at the assertion level. Read-ers may consider this guidance when designing and performing substantive tests.
7.152 Chapter 7 of the Audit Guide Auditing Derivative Instruments, Hedging Activities, and Investments in Securities specifically addresses deriva-tives and securities measured or disclosed at fair value, various methods for determining fair value as specified by U.S. GAAP, and evaluating audit ev-idence for the valuation assertion of derivative and securities. Readers may consider this guidance when designing and performing substantive tests.
7.153 AU section 328 addresses audit considerations relating to the mea-surement and disclosure of assets, liabilities, and specific components of equity presented or disclosed at fair value in financial statements. The auditor should obtain sufficient appropriate audit evidence to determine that fair value mea-surements and disclosures are in conformity with GAAP. As stated in paragraph .15 of AU section 328, the auditor's understanding of the requirements of GAAP and knowledge of the business and industry, together with the results of other audit procedures, are used to evaluate the accounting for assets or liabilities requiring fair value measurements, and the disclosures about the basis for the fair value measurements and significant uncertainties related thereto.
7.154 As stated in paragraph .20–.21 of AU section 328, the auditor should consider whether to engage a specialist and use the work of that specialist as audit evidence in performing substantive tests to evaluate material financial statement assertions. When planning to use the work of a specialist in auditing fair value measurements, the auditor considers whether the specialist's under-standing of the definition of fair value and the method that the specialist will use to determine fair value are consistent with those of management and with GAAP.
7.155 Paragraph .23 of AU section 328 states that based on the auditor's assessment of the risks of material misstatement, the auditor should test the entity's fair value measurements and disclosures. Because of the wide range of possible fair value measurements, from relatively simple to complex, and the varying levels of risks of material misstatement associated with the process for determining fair values, the auditor's planned audit procedures can vary AAG-DEP 7.150
Investments in Debt and Equity Securities
167
significantly in nature, timing, and extent. For example, substantive tests of the fair value measurements may involve (a) testing management's significant assumptions, the valuation model, and the underlying data (see paragraphs .26–.39 of AU section 328), (b) developing independent fair value estimates for corroborative purposes (see paragraph .40 of AU section 328), or (c) reviewing subsequent events and transactions (see paragraphs .41–.42 of AU section 328).
7.156 AU section 342, Auditing Accounting Estimates (AICPA, Profes-sional Standards, vol. 1), provides guidance to auditors on obtaining and eval-uating sufficient appropriate audit evidence to support significant accounting estimates in an audit of financial statements in accordance with generally ac-cepted auditing standards. The auditor's objective when evaluating accounting estimates is to obtain sufficient appropriate audit evidence to provide reason-able assurance of the following:
a. All accounting estimates that could be material to the financial statements have been developed.
b. Those accounting estimates are reasonable in the circumstances.
c. The accounting estimates are presented in conformity with appli-cable accounting principles and are properly disclosed.
7.157
Considerations for Audits Performed in Accordance with Public Com-pany Accounting Oversight Board (PCAOB) Standards6
Paragraph .02 of AU section 319, Consideration of Internal Control in a Financial Statement Audit (AICPA, PCAOB Standards and Related Rules, Interim Standards), states that regardless of the assessed level of control risk, the auditor should perform substantive procedures for all relevant assertions related to all significant accounts and disclo-sures in the financial statements. Refer to paragraph A9 of appendix A, "Definitions," of PCAOB Auditing Standard No. 5, An Audit of Inter-nal Control Over Financial Reporting That Is Integrated with An Au-dit of Financial Statements (AICPA, PCAOB Standards and Related Rules, Auditing Standards), for the definition of a relevant assertion, and paragraphs 28–33 of Auditing Standard No. 5 for discussion of identifying relevant assertions.
Paragraph .01 of AU section 324, Service Organizations (AICPA, PCAOB Standards and Related Rules, Interim Standards), states that when performing an integrated audit of financial statements and in-ternal control over financial reporting, refer to paragraphs B17–B27 of appendix B, "Special Topics," of Auditing Standard No. 5.
PCAOB Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Spe-cialists (AICPA, PCAOB Standards and Related Rules, PCAOB Staff Guidance, sec. 400 par. .02), provides guidance on auditors' responsi-bilities for auditing fair value measurements of financial instruments and when using the work of specialists under the existing standards of the PCAOB. This alert is focused on specific matters that are likely to increase audit risk related to the fair value of financial instruments
6Public Company Accounting Oversight Board Staff Audit Practice Alerts are not rules of the board, nor have they been approved by the board.
AAG-DEP 7.157
168
Depository and Lending Institutionsin a rapidly changing economic environment. This practice alert high-lights certain requirements in the auditing standards related to fair value measurements and disclosures in the financial statements and certain aspects of U.S. GAAP that are particularly relevant to the eco-nomic environment.
PCAOB Staff Audit Practice Alert No. 3, Audit Considerations in the Current Economic Environment (AICPA, PCAOB Standards and Re-lated Rules, PCAOB Staff Guidance, sec. 400 par. .03), assists auditors in identifying matters related to the current economic environment that might affect audit risk and require additional emphasis. This practice alert is organized into 6 sections (1) overall audit considera-tions; (2) auditing fair value measurements; (3) auditing accounting estimates; (4) auditing the adequacy of disclosures; (5) auditor's con-sideration of a company's ability to continue as a going concern; and (5) additional audit considerations for selected financial reporting areas.
AAG-DEP 7.157
Loans
169
Chapter 8
Loans
Introduction
8.01 Loans usually are the most significant assets of financial institutions and generate the largest portion of revenues. Like investments, an institution's management of its loans is an integral part of its asset/liability management strategy (discussed in chapter 1, "Industry Overview—Banks and Savings In-stitutions"). Institutions originate loans, purchase loans or participating inter-ests in loans, sell loans or portions of loans, and securitize loans (the latter two activities are discussed in chapter 10, "Transfers and Servicing—Including Mortgage Banking"). The composition of loan portfolios differs considerably among institutions because lending activities are influenced by many factors, including the type of institution, management's objectives and philosophies re-garding diversification and risk (credit strategy), the availability of funds, credit demand, interest-rate margins, and regulations. Further, the composition of a particular institution's loan portfolio may vary substantially over time.