UNIVERSITY OF JOHANNESBURG

DEPARTMENT OF ACCOUNTANCY

AUDITING 3A

2013

INVESTMENT AND FINANCE CYCLE

INDEX:

A PRE-READING
B INTRODUCTION
C CHARACTERISTICS OF THE CYCLE
D COMPONENTS AND FUNCTIONS OF THE CYCLE
E RISKS AND CONTROLS IN THE CYCLE
F ADDITIONAL NOTES
G QUESTIONS RELATING TO THE CYCLE
PART A: PRE-READING
 PART B: INTRODUCTION

1. PRIOR KNOWLEDGE

You are not expected to have any prior knowledge of the topic.

2. RESOURCES

In order to master this topic you should make use of the following
resources:

2.1 Pre-reading;
2.2 Lecture notes;
2.3 Module;
2.4 Question Bank.

3. STUDY OUTCOMES

After you have completed your studies of this topic you must be able to:

3.1 Understand the risks inherent within the cycle;

3.2 Be able to understand and recommend controls to be implemented
in order to mitigate risks;
3.3 Be able to apply your knowledge to any given scenario.

4. EXAMINATION POSSIBILITIES

The topic can be tested in any one of the following ways:

4.1 Theory application;

4.2 Scenario based application.
 PART C: CHARACTERISTICS OF THE CYCLE

A company can raise funds by way of a share or debenture issue or through

obtaining loan capital. The funds are used to purchase fixed assets which will
enable the company to commence business. From time to time the company will
also be required to raise funds for the expansion of the business or the
replacement of worn out assets. The cycle that controls the funding and investing
in fixed assets is the Investment and Finance cycle.

This cycle mainly deals with:

 Raising of finance (funds) and the repayment thereof;
 Obligations which arise out of the finance raised (interest and dividends);
 The application of funds raised for the acquisition of assets.

One of the characteristics of the cycle is that there are relatively few transactions
that occur during an entity’s reporting period. For example, most companies only
purchase a few assets every year and new shares are not issued on a continuing
basis.

Another important characteristic of the cycle is that the transactions within this
cycle are usually material. Generally the expansion of a business or the
continuing replacement of assets requires substantial funding.

Lastly the transactions in this cycle are frequently governed by legal and
regulatory requirements. The Companies Act governs majority of the transactions
within this cycle.

This cycle presents the directors of a company with a fair number of opportunities
to report fraudulently as there are numerous accounts which can be manipulated.
Some examples of fraud in this cycle consist of the following:
 Omitting long term liabilities (loans) from the FS;
 Understating the value of long term liabilities (loans);
 Overstating assets by including fictitious assets or assets which the
company does not own;
 Overstating assets by understating depreciation allowances or
impairment.
 PART D: COMPONENTS AND FUNCTIONS OF THE CYCLE

The Investment and Finance Cycle can be divided into two components:

1. INVESTMENT ACTIVITIES
2. FINANCING ACTIVITIES

1. INVESTMENT ACTIVITIES

Investment activities comprise of the acquisitions, disposal and management

(repair and maintenance) of tangible and intangible assets.

Within this cycle one can be encountered with the following type of transactions
and accounts:

Transaction Account debited Account credited

Purchase of assets Land & Buildings, Accounts payable

Capitalization of assets Plant & equipment Long-term loans
Bank
Lease accounts
Disposal of assets Accounts receivable Land & Buildings, Plant &
Accumulated Equipment
Depreciation, Loss on
disposal
Purchase/ Goodwill Accounts payable
development of intangible Patents, trademarks, Bank
assets Research & development
Revaluation Land & Buildings Revaluation reserve
Plant and Equipment (NDR)
Depreciation Depreciation expense Accumulated
depreciation

KEY DOCUMENTS AND RECORDS USED IN THE INVESTMENT CYCLE

As in any cycle it is of utmost importance that we are aware of the documentation

that can be found within this cycle.

The documentation present within the investment activities of this cycle can be
summarized as follow:

Capital budgets
Fixed Asset requisition with quote/negotiated prices
Minutes of Board of Directors (authorisation of purchases and sales)
Invoices (purchases and sales)
Fixed Asset register
General Ledger accounts:
 Fixed Assets
 Depreciation
 Profit/Loss on disposal
 Accumulated depreciation

ACITIVITIES IN THE INVESTMENT CYCLE

The main activities in the investment cycle can be divided into 3 components:

1. Additions of fixed assets;

2. Disposals of fixed assets;
3. Repair and maintenance of assets.

1) ADDITIONS OF FIXED ASSETS:

One of the most important aspects for the acquisition of an asset relates to the
authorisation that must be obtained.

The following steps must be taken before an asset can be acquired:

 A formal written proposal by a capex committee must be completed;
 The proposal must be supported by quotes and the required source of
finance;
 The proposal must then be presented to the Board of Directors;
 The decision taken by the directors must be minuted;
 In large organisations different levels of authorisation must be obtained
for the acquisition of assets;
 If any director has an interest in a contract for the purchase of assets,
this interest must be disclosed (Company Act requirement);
 With the approval of the purchase of an asset, the usual issue of
purchase order/delivery note from supplier/invoice will be used as
supporting documentation;
 In some cases a formal signed contract is required for the purchase of
the asset.

2) DISPOSAL OF FIXED ASSETS

 The proceeds from disposals usually take the form of:

o Cash receipts or
o Trade-in values
 Normally entities have less formal controls around disposal of their assets
and therefore the accurate accounting can be overlooked;
  The major risk of disposal relates to the fact that disposed assets can still
be reflected as assets in the statement of financial position in an attempt
to overstate assets.

3) REPAIR AND MAINTENANCE OF ASSETS

The major concern within the repair and maintenance activity of the investment
cycle is the risk that costs incurred for repair and maintenance are incorrectly
treated. The risk exists that items are capitalised instead of expensed in the
attempt to overstate profits or that an item is incorrectly expensed instead of
capitalised.
 2. FINANCE ACTIVITIES

Financing activities are the means by which the entity obtains it’s funding for
business operations and capital investments. Funding is obtained from two main
external sources, namely owners’ equity and borrowings.

Owner’s Equity:
For owners equity the following activities must be considered:
 Issue of shares;
 Share buy backs;
 Statutory requirements (Companies Act);
 Authorisation for the issue of shares;
 Declaration of dividends.

Borrowings:
For borrowings the following activities must be considered:
 Cash inflow from long-term/short-term borrowings received;
 Subsequent repayment of capital sum;
 Interest charged on borrowings;
 Authorisation required for borrowings;

Within this cycle one can be encountered with the following type of transactions
and accounts.

Transaction Account debited Account credited

Issue of shares Bank Share capital
Retained income Various income/expense Retained income
accounts = net income
Dividends declared Dividends declared Shareholders for dividend
Bank
Shareholders for dividend
Share buy-backs Share capital Bank
Loans/Borrowings Bank Lender
Loans repaid Lender Bank
Interest paid Interest expense Bank
Lease assets acquired Capitalized lease asset Lease creditor
Finance charges Finance charges Lease creditor
Payments expense Bank
Interest paid Lease creditor Bank
Interest expense
KEY DOCUMENTATION WITHIN THE FINANCE CYCLE

The documentation present within the investment activities of this cycle can be
summarized as follow:

Common Documents Details

 Minutes of  Provide approval for share
shareholders/directors issue,
debenture share buy-back,
dividends declared
 Debenture trust deed  Terms of debenture issue and
rights & obligation of debenture
holders.
 Prospectus  Document prepared for public
share offering containing all
details regarding issue.
 Share certificate  Evidence of ownership given to
shareholder, detail number &
type of share
 Loan/lease contract  Terms of loan/lease, amount,
repayment terms interest rate
and security
 Mortgage bond  Agreement signed over property
to secure repayment of loan
 Journal voucher  Several entries made by journal
–interest calc, finance lease
payments.
 PART E: RISKS AND CONTROLS IN THE CYCLE

Now that you are familiar with the functions of this cycle, you need to gain an
understanding of the risks inherent in the cycle and the controls that need to be
implemented to mitigate the evident risks. This section will also take it a step
further and test the implementation of the control.

RISKS INHERENT IN THIS CYCLE:

 Management bias and incentive to misstate capital expenditure to achieve

budget and obtain performance bonuses;
 Nature and complexity of the assets acquired leading to errors in
accounting, such as property;
 Valuation of intangible assets for example goodwill & brands;
 Determining useful lives of assets or fair market values;
 Risk of management override of controls through unauthorized
acquisitions;
 Risk of fraud and theft of assets;
 Errors in the recording of assets.
TEST OF CONTROLS

It is not sufficient for management to just implement controls. They will need to
also test the controls to determine if the controls implemented meet the
objectives as set out by management.

Below is a table setting out the following:

i. Objective to be achieved by the control to be implemented (incl. definition)
ii. Internal Control: How the objective will be achieved.
iii. Test of control: How to test the implementation of the control.

Occurrence/Validity: All recorded assets are valid (really exist) and are
supported by proper documentation

Internal Control Test of Control

1) All fixed asset purchases are 1) Select a few fixed asset purchases
supported by a fixed asset requisition and inspect the supporting requisition
and capital budgets. (Supporting and capital budget.
documentation).
2) Enquire with the client's personnel
2) Recorded assets are periodically about the procedures i.r.o. purchasing
compared to physical assets by an of fixed assets and periodic
independent senior official. comparison of fixed assets with book
assets.

3) Inspect proof of comparisons by

client official (signature).

Authorisation: All purchases and sales are authorised according to

company’s policy

Internal Control Test of Control

1)Purchases and sales of fixed assets: 1) Enquire with the client personnel
about the policy i.r.o. authorisation of
- authorised by senior management on purchases and sales.
a numerical capital requisition/sales
document; 2) Inspect supporting documentation
and minutes as proof of authorisation.
- Authorisation/decision recorded in
minutes.
Completeness: All valid fixed assets are recorded and nothing is omitted

Internal Control Test of Control

1) Capital requisitions are numerically 1) Inspect capital requisitions for
accounted for (Sequentially pre- numerical sequence and proof of client
numbered). review (signature).

2) The list of missing numbers is 2) Inspect the fixed asset register for
regularly followed up. proof of review (signature).

3) Fixed assets are recorded in a fixed

asset register and are regularly
compared with fixed assets (see refer
to the test under validity.

Accuracy: All fixed assets are recorded at the correct amount and are
arithmetically correct

Internal Control Test of Control

1) Fixed assets are recorded at the 1) Enquire about procedures followed.
amount of the invoice.
2) Test the functioning of programmed
2) Depreciation and other calculations controls (e.g. test date). If calculation
are done by computer with a program performed by hand, inspect schedules
which has been tested beforehand (if for proof of client review of calculation.
calculation is per hand, perform an
independently reviewed on calculation).

Recording: All transactions i.r.o. fixed assets and depreciation are

correctly recorded

Internal Control Test of Control

1) All purchases and sales of fixed 1) Select purchases and sales of fixed
assets are recorded in the fixed asset assets from the cash book and follow it
ledger accounts (control account) and through to the source documents, fixed
fixed asset register from the source asset register and entries in the ledger.
documents. Agree details such as the date,
amount, description and category of
2) The fixed asset register is reconciled asset.
with the control accounts in the ledger
on a regular basis. 2) Inspect the reconciliation and agree
it with the accounting records and
source documents.

3) Inspect the reconciliation for proof of

review by a senior employee at the
 client.
Classification: All transactions i.r.o. fixed assets are correctly classified
according to its nature

Internal Control Test of Control

1) Fixed assets are classified into the 1) Verify procedure by means of
respective categories according to enquiries.
company policy.
2) Review the fixed assets register and
2) Improvements are capitalised as the ledger accounts for maintenance
fixed assets and clearly distinguished costs that have been erroneously
from maintenance. classified.

Cut off: All purchases and sales of fixed assets are recorded in the period
to which it relates

Internal Control Test of Control

1) Fixed assets purchased are 1) Enquire about procedures i.r.o.
recorded at the date of receipt (per recording and cut-off.
GRN) and when sold as from the date
that the risks and rewards of ownership 2) Select purchases and sales from
passes to the purchaser in substance source documents and follow it through
to the ledger accounts and fixed asset
register - ensure recorded in correct
period. (Test also in other direction
from records to supporting
documentation).

General Controls: Assets are properly safeguarded against theft and

physical elements

Internal Control Test of Control

1) Fixed assets are, as far as possible, 1) Enquire with personnel about
stored in permanent form (bolted). procedures i.r.o. safeguarding.

2) Observe procedures i.r.o.

safeguarding.
2) Safe guard assets by:
 Limiting access to authorised 3) Investigate company policy and
persons (locked, key control) proof of application.
 Controls protecting assets
against physical elements (rain, 4) Confirm by way of enquiry and
weather) inspection of insurance contracts that
the assets are insured.
3) Asset adequately insured
 PART F: ADDITIONAL INFORMATION

In this section you will find documents pertaining to this topic.

PART G: QUESTIONS RELATING TO THIS TOPIC

QUESTION BANK

Refer to question bank at the end of the module.

SOLUTIONS TO QUESTION BANK QUESTIONS

These will be given to you on the completion of each module. The solutions will
also be available on Edulink NextGen.