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 [email protected] Mark is a Principal with Firley Moran, Freer & Eassa, P.C. and is a Certified Public Accountant with 19 years of public accounting experience providing auditing, accounting and tax services to clients. Mark’s client service experience primarily includes credit unions and credit union service organizations. Mark has an extensive background in providing auditing, accounting, tax and regulatory compliance services, and internal control evaluations to credit unions. Mark manages various projects for thirteen credit union clients ranging in asset size from $26 million to over a billion dollars. Mark also heads the firm’s internal audit co-sourcing and regulatory compliance engagements. He has designed internal audit programs, assisted in creating internal audit departments and oversees the internal audit and compliance work. James Flynn, CPA Mark holds a position as Treasurer on the Board of Directors of the Central New York March of Dimes and is a Director on the Board of the Fairmount Community Library. Mark received his Bachelor of Science degree from LeMoyne College and is currently a member of the ACUIA, AICPA and the NYSSCPAs. Jim is a member of the ACUIA, AICPA and the NYSSCPAs, holds a Bachelor of Science degree, with distinction, from Clarkson University and serves his community as the fire chief of a local volunteer fire company. [email protected] Jim is a Senior Manager with Firley, Moran, Freer & Eassa, P.C. and is a Certified Public Accountant with 18 years of public accounting experience providing auditing, accounting, consulting, tax and forensic services to clients. Four of his 14 years of public accounting experience were with PricewaterhouseCoopers (formerly Coopers & Lybrand), where he had a concentration in financial institutions and insurance. He currently serves clients in the credit union, group self-insurance and construction industries, including a specialization in auditing employee benefit plans. Jim has been involved with the credit union movement since college when he worked as a teller at a local credit union. He currently performs services for eight of our credit union clients ranging in size from $90 million to over $1 billion in assets. 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), heldto-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 unaccreated 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-tomaturity 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-thecounter 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-thantemporary 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.