McNeil Company, a medium-sized manufacturer of microwaveovens, has been an audit client for the past five years. McNeil Co. has been steadily growingand recently hired a new CEO who has decided to increase the level of investments infinancial instruments as a way of generating a profit from excess cash from operations.The new CEO has invested primarily in actively-traded equity securities, but has alsoinvested a portion of the cash in speculative derivative financial instruments. McNeilCo. is using a brokerage firm to execute trades, but the CEO is making the decision as towhich securities and derivatives to purchase and sell.In planning for the current year’s audit engagement, you note the following related to theinvestments in financial instruments:1. The CEO discusses the investment strategy with the board of directors, but theboard is not involved in the purchase and sale decisions and does not approvederivative contracts. The CEO enters into the speculative derivative financialinstruments on behalf of McNeil Co.2. Total investments in financial instruments (trading and available-for-salesecurities) at year-end represent approximately 15% of total assets. The majority ofinvestments are classified as trading securities, and many of the equity investmentswould be considered high risk stocks.3. The CEO makes the determination to classify securities as trading or availablefor-sale.4. McNeil Co. has recorded significant gains on sales of financial instruments.5. The new CEO has an incentive to continue to grow the company and report aprofit because he has been given an incentive bonus based on return on assets.a. Identify the inherent and control risks related to the financial instruments accountsfor McNeil Co.b. Identify at least two audit procedures the auditor would perform to test the existencebalance-related audit objective for the trading and available-for-sale securities.c. How would the auditor test the completeness balance-related audit objective for thespeculative derivative financial instruments?d. Identify at least two audit procedures the auditor would perform to test the realizablevalue balance-related audit objective for the financial instruments accounts. Assumethe investments in stock are all actively-traded in a liquid market, but the derivativefinancial instruments require a level 3 fair value estimate.e. In your opinion, would the audit of financial instruments require the use of avaluation specialist? Why or why not?
McNeil Company, a medium-sized manufacturer of microwave
ovens, has been an audit client for the past five years. McNeil Co. has been steadily growing
and recently hired a new CEO who has decided to increase the level of investments in
financial instruments as a way of generating a profit from excess cash from operations.
The new CEO has invested primarily in actively-traded equity securities, but has also
invested a portion of the cash in speculative derivative financial instruments. McNeil
Co. is using a brokerage firm to execute trades, but the CEO is making the decision as to
which securities and derivatives to purchase and sell.
In planning for the current year’s audit engagement, you note the following related to the
investments in financial instruments:
1. The CEO discusses the investment strategy with the board of directors, but the
board is not involved in the purchase and sale decisions and does not approve
derivative contracts. The CEO enters into the speculative derivative financial
instruments on behalf of McNeil Co.
2. Total investments in financial instruments (trading and available-for-sale
securities) at year-end represent approximately 15% of total assets. The majority of
investments are classified as trading securities, and many of the equity investments
would be considered high risk stocks.
3. The CEO makes the determination to classify securities as trading or availablefor-sale.
4. McNeil Co. has recorded significant gains on sales of financial instruments.
5. The new CEO has an incentive to continue to grow the company and report a
profit because he has been given an incentive bonus based on return on assets.
a. Identify the inherent and control risks related to the financial instruments accounts
for McNeil Co.
b. Identify at least two
balance-related audit objective for the trading and available-for-sale securities.
c. How would the auditor test the completeness balance-related audit objective for the
speculative derivative financial instruments?
d. Identify at least two audit procedures the auditor would perform to test the realizable
value balance-related audit objective for the financial instruments accounts. Assume
the investments in stock are all actively-traded in a liquid market, but the derivative
financial instruments require a level 3 fair value estimate.
e. In your opinion, would the audit of financial instruments require the use of a
valuation specialist? Why or why not?
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