Investments: Policies, Internal controls and how to audit

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Investments Policies, Internal controls and how
to audit

• Presented by
• William Blend, CPA, CFE

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Investments Current Environment
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Current Environment

• Global financial crisis
• SBA
• City of Vallejo
• Downgrade of municipal bonds

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Some Investment Basics
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What are Investments?

• Cash
• Certificates of Deposit
• Money Market Funds
• Treasury Securities
• Strip Bonds (Zero Coupon)
• High Quality Corporate Bonds
• Bond Funds
• Blue Chip and High Quality Stocks
• Hedge Funds

• Stock Mutual Funds
• Moderate Yield Bonds
• Stock Options
• SBA
• Investment Pools (internal or external)
• Repurchase agreements

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Investment Terminology

• Broker
• Refers to the party that mediates the investment
  transaction.
• Trustee / Custodian
• Refers to a holder of property on behalf of a
  government.
• Financial Advisor
• Professional who renders investment advice and
  financial planning services

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Relationships Between Government and
Broker/Trustee

• Directed Relationship
• Trustee or broker acts as custodian of an
  entitys investments and is responsible for
  collecting investment income and handling asset
  transactions
• Transactions Directed By the Government
  Representative, such as the investment
  administrator, governments investment committee,
  or the governments investment advisor

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Relationships Between Government and
Broker/Trustee

• Discretionary Relatioinship
• Trustee/broker has discretionary authority and
  control over investments and is Authorized by the
  entity or its investment committee to make
  investment decisions
• A discretionary relationship gives the
  trustee/broker Authority to purchase and sell
  investment assets within the framework of the
  trust instrument

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Accounting for Investments

• Investment subsidiary ledger
• Accounts for detail investment activity by class
  or investment.
• Often a separate program from the entitys
  primary accounting software

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Investment Policies
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Investment Policies

• Association of Public Treasurers of the United
  States Canada (APT)
• Provide education and training, professional
  certification for public treasury and financial
  officials
• Certification program for investment policy
• Link - http//www.aptusc.org/index.php

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Investment Policies

• FL 218.415  Local government investment policies
• Investment activity by a unit of local
  government must be consistent with a written
  investment plan adopted by the governing body

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Investment Policies

• FL Statute 218.415  Local government investment
  policies (cont.)
• In the absence of an adopted policy, units of
  governments must be in accordance with subsection
  17 of the statute
• Subsection lists all authorized investments for
  governments without a policy

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Investment Policies

• The investment policys objective is to
• Provide the internal or external cash manager
  with guidelines
• Outline structuring and monitoring of the
  portfolio
• Identifying allowed investments and concentration
  limits
• Identifying the stated risk tolerance levels for
  investments
• Ensure investments do not compromise liquidity
  requirements.

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Investment Policies

• Prior to drafting the investment policy, a
  government should determine
• Basic cash management strategy and goals
• Safety
• Liquidity
• Yield
• Determine if an investment committee will be used

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Investment Committee

• A government may create an investment committee.
  Investment committees provide implementation and
  monitoring for the guidelines set within the
  investment policy.
• They can also be charged with creation and
  review of the investment policy.

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Investment Committee

• Committee duties include
• Setting benchmarks
• Reviewing portfolio activities and performance
• Selection of investment broker and advisor
• Reporting to governing body

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Investment Committee

• Committee composition
• Should involve at least 3 people
• Should have a range of experience and outlooks

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Investment Policies

• Properly drafted investment policies generally
  comprise four main sections
• Authorization (Who What)
• Concentration Limits (Who What)
• Maturity Structures
• Credit Ratings

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Investment Policies

• Authorization
• Who government representative, brokers,
  trustees, etc.
• What - specify the types of investments
  authorized

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Example of Authorization
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Example of Authorization
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Investment Policies

• Concentration Limits
• Specifies the maximum acceptable exposure to any
  single issuer
• It governs the degree of issuer "event risk" in
  the portfolio. Event risk is the risk due to
  unforeseen events partaken by or associated with
  an entity

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Investment Policies

• Concentration Limits (cont.)
• Concentration limits generally restrict the
  amount invested in the securities of any single
  issuer
• Depending on portfolio size and other
  considerations, managers generally maintain
  concentration limits at levels significantly
  lower than the specified maximums

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Example of Concentration Limits
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Investment Policies

• Maturity Structure
• The policy should address the following
  components
• Maximum Maturity
• Maximum Weighted Average Maturity (WAM)
• Minimum Liquidity Percentage

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Example of Maturity Structure
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Investment Policies

• Credit Ratings
• Governs the minimum acceptable short- and
  long-term ratings in the portfolio
• Because different types of securities have
  different risk profiles, ratings may vary by
  security class

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Investment Policies
Below is from section VIII of the Example
Investment Policy
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Investment Policies

• Other areas to address
• Scope of Investment Policy
• Prudence and Ethical Standard
• Investment Objectives
• Delegation of Authority
• Third Party Custodial Agreements
• Internal Controls

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Investment Policies

• Other areas to address (cont.)
• Reporting
• Investment Officer
• Continuing Education
• Bid Requirements
• Money Managers
• Policy Adoption and Review

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Investment Policies

• Common Mistakes
• Deficiencies within the investment policy often
  result in issues governments are required to
  address and resolve as a result of the
  independent audit process. These include

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Investment Policies

• Using Vague Terminology (cont.)
• "Best net price" is a subjective term and, due
  to the constantly changing supply of particular
  securities, it is nearly impossible to quantify
• In the case of dealers, there are no universally
  accepted definitions of "reputable" or
  "principal."

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Investment Policies

• Specifying Concentration Limits by Only Security
  Type
• Referencing such limits may be beneficial,
  including highly detailed concentration limits
  often requires frequent revision to the
  investment policy
• These allocations may appear to reduce risk,
  however, they do not necessarily achieve that
  objective

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Investment Policies

• Neglecting to Use Credit Rating Modifiers
• Since these modifiers effectively split single-
  and double-A ratings grades into three
  sub-categories, use of modifiers is recommended

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Investment Policies

• Tying Maturity Structures to Security Type
• Assigning a different maximum maturity to
  different types of securities limits the
  portfolio manager's ability to purchase the most
  attractive securities on a relative value basis
  at a particular maturity point

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Internal Controls
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Internal Controls

• Internal Controls for Investments
• Government should have a written investment
  policy that has been approved by the governing
  body
• Policy should be reviewed and revised
  periodically. All changes should be approved by
  the governing body
• Process of initiating, reviewing, and approving
  investment purchases and sales should be recorded
  and retained for audit purposes

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Internal Controls

• Internal Controls for Investments (cont.)
• Government should have a written wire transfer
  agreement, which outlines controls and security
  provisions for making and receiving wire
  transfers.
• Written confirmations of telephone transactions
  for investments and wire transfers should be
  required.
• Duties should be segregated so no one person has
  responsibility for investment transactions from
  beginning to end.

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Internal Controls

• Internal Controls for Investments (cont.)
• Investment procedures should be fully documented,
  should include descriptions of employee
  responsibilities, the process for conducting and
  recording transactions, and outline the authority
  to approve the transactions.
• Government should have a training plan
• Monthly verifications of both principal and
  market values of all investments and collateral
  should be obtained

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Internal Controls

• Internal Controls for Investments (cont.)
• Investment reports should be produced on a
  periodic basis and presented to the governing
  body.
• Periodic internal control audits should be
  performed to verify that controls are functioning
  properly and in compliance with investment policy.

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Audting Investments
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AUDITING INVESTMENTS

• Audit Objectives
• Understanding the Client and Controls
• Risk Assessment
• Audit Procedures

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Audit Objectives

• Assertion Categories
• Existence or Occurrence
• Completeness
• Rights and Obligations
• Valuation or Allocation
• Accuracy or Classification
• Cutoff
• Presentation and Disclosure

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Audit Objectives

• Assertions
• Existence or occurrence
• Investment revenues, realized and unrealized
  gains and losses
• Recorded short and long term investments
  represent investments that exist at the balance
  sheet date

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Audit Objectives

• Assertions (cont.)
• Completeness
• Income statement effects of all investment
  transactions
• All short and long term investments are
  included in the balance sheet investment
  accounts.

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Audit Objectives

• Assertions (cont.)
• Valuation or allocation
• Investment revenues, realized and unrealized
  gains and losses are reported amounts.
• Investments are reported on the balance sheet
  at fair value, cost, amortized cost, or the
  amount determined by the equity method, as
  appropriate for particular investments

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Audit Objectives

• Assertions (cont.)
• Rights and Obligations
• All recoded investments are owned by the
  reporting entity
• Accuracy and Classification
• All recorded investments occurring during the
  period mathematically correct and entered in the
  proper accounts

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Audit Objectives

• Assertions (cont.)
• Cutoff
• Investment transactions are recorded in the
  proper accounting period
• Presentation and Disclosure
• Investment balances are properly identified and
  classified in the financial statements.
  Appropriate disclosures made for investment
  portfolio

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Understanding the Client and Controls

• Key Company Personnel
• Finance Clerk/Receptionist
• Accountant
• Senior Accountant
• Investment Committee or Investment Manager

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Understanding the Client and Controls

• Investment Processes/Procedures
• Preparing reconciliation to statements
• Review of reconciliation
• Preparing journal entries
• Investment of excess operating funds
• Interest recording
• Market adjustments
• Sales and purchases
• Redemptions

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Understanding the Client and Controls

• IT Systems
• Client financial software
• Financial institution software
• Security Controls
• Work Flow
• Detailed process of transactions from initiation
  to end

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Understanding the Client and Controls

• What allows the government to engage in
  investing activities, its financing activities,
  and its ability to generate excess cash?

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Risk Assessment

• Factors Affecting Inherent Risk
• Susceptible to theft
• Can management manipulate the reporting for
  investments
• Types of investments held
• Are investment classifications contentious

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Risk Assessment

• Factors Affecting Control Risk
• Does client review investment returns for
  accuracy
• Does client review and record appropriate asset
  class
• Is there an Investment Committee?
• Does the client have appropriate segregation of
  duties (Dependent of Entity Size) related to
• Approval of investing and borrowing
• Recording of investing and borrowing
• Reconciling investing and borrowing

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Risk Assessment

• Factors Affecting Control Risk (cont.)
• Are the policies and procedures in place which
  specify the correct treatment for valuing
  investments
• Are adjustments to investments properly reviewed
  and recorded

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Risk Assessment

• Materiality Considerations
• Are investments material to the entitys
  financial statements?

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Audit Procedures

• Auditing investments vary significantly from one
  government to another
• Agree the beginning investment balances with
  audited amounts in the prior years work papers
• Review general ledger to determine the presence
  of any entries that are unusual in nature or
  amount

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Audit Procedures

• Check client-prepared schedules for mathematical
  accuracy and agreement with the underlying
  accounting records
• Agree client schedules to subsidiary ledgers and
  related general ledger control accounts. These
  schedules can then serve as the basis for
  additional substantive tests

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Audit Procedures

• Analytical Procedures
• An important part of the investing cycle is
  determining that the financial information
  subjected to audit is consistent with the
  auditors expectations
• Inquiry of client on any noted variance from
  investing balances and activities
• Use results as part of analysis of additional
  testing to be performed

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Audit Procedures

• Analytical Procedures (cont.)
• Analytical procedures may compare current-year
  and prior-year balances
• Compare actual results of investments and
  investment income with budgets or other
  documentation of managements plans

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Audit Procedures

• Test of yearend balances and activities
• Inspect and count securities on hand
• Confirm securities held by others, and
• Recalculate investment revenue earned

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Audit Procedures

• Test of transactions
• Recording purchases, sales, and income
• Recording market adjustments and
  reclassifications
• Settle transactions
• Receiving cash
• Disbursing cash

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Audit Procedures

• Assess investment performance and reporting
• Performance reviews are made by management to
  detect poor investment performance and/or
  erroneous reporting
• Includes comparisons of investment balances
• Rates of return for various classes of
  investments Budgeted amounts
• Propriety of the classification of individual
  investments

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Questions?