12.2 Investments in Securities, Derivatives & Equity-Method Investees
Key Takeaways
- Trading and available-for-sale debt securities are measured at fair value, with unrealized changes in net income for trading and other comprehensive income for available-for-sale.
- Held-to-maturity debt securities are carried at amortized cost less an allowance for credit losses and require the positive intent and ability to hold them to maturity.
- Confirmation with a custodian or broker, inspection, and the custodian's SOC 1 Type 2 report provide evidence of existence and rights, but not valuation.
- For Level 2 and Level 3 investments, the auditor evaluates valuation methods, significant assumptions, and data under AU-C 540, often with a valuation specialist.
- Equity-method evidence centers on the investee's financial statements and audit report, significant influence, reporting lags of up to three months, and impairment indicators.
12.2 Investments in Securities, Derivatives & Equity-Method Investees
Blueprint Link: Area III.E.2 asks you to identify considerations for the measurement and disclosure of the fair value of investments in securities, and to test management's assumptions, conclusions, and adjustments related to their valuation. Investments combine existence risk (securities held by others), classification judgments, and valuation estimates.
1. The Accounting the Auditor Tests Against
| Investment Type | Measurement | Where Changes Go | Key Judgment |
|---|---|---|---|
| Trading debt securities (ASC 320) | Fair value | Net income | Classification at acquisition |
| Available-for-sale debt securities (ASC 320) | Fair value | Other comprehensive income, with credit losses through an allowance (ASC 326-30) | Credit loss versus noncredit decline |
| Held-to-maturity debt securities (ASC 320) | Amortized cost less an allowance for credit losses (ASC 326-20) | Credit losses in net income | Positive intent and ability to hold to maturity |
| Equity securities with readily determinable fair value (ASC 321) | Fair value | Net income | Reliability of the price source |
| Equity securities without readily determinable fair value (ASC 321) | Fair value, or the measurement alternative: cost less impairment, adjusted for observable price changes in orderly transactions for the same or similar securities of the issuer | Net income | Identifying observable transactions and impairment indicators |
| Equity-method investments (ASC 323) | Cost adjusted for the investor's share of investee earnings and dividends | Share of earnings in net income | Significant influence (presumed at 20% to 50% of voting stock) and declines in value that are other than temporary |
| Derivatives (ASC 815) | Fair value | Net income, unless hedge accounting applies | Hedge documentation and effectiveness |
2. Assertions and Audit Procedures
| Assertion | Key Risks | Procedures |
|---|---|---|
| Existence | Securities recorded but not held | Confirm holdings with the custodian, broker, or transfer agent; inspect securities held on site (counted together with cash and other negotiable items); use the custodian's SOC 1 Type 2 report |
| Rights and obligations | Securities pledged, lent, or held for others | Read board minutes, loan agreements, and bank confirmations for pledges; review custodial agreements |
| Completeness | Unrecorded holdings or purchases | Reconcile broker and custodian statements to the ledger; scan investment income (interest and dividends) for holdings not on the ledger; review subsequent-period statements |
| Valuation | Misstated fair value or credit losses | Agree Level 1 prices to independent sources; for Level 2 and 3, evaluate methods, test significant assumptions and data, or develop an independent estimate under AU-C 540, often with a valuation specialist; evaluate credit loss assumptions for HTM and AFS securities |
| Classification and presentation | Wrong category or incomplete disclosure | Test HTM intent and ability, including past sales from the portfolio; review current versus noncurrent classification; test fair value hierarchy disclosures |
| Accuracy of investment income | Misstated interest, dividends, or gains | Recompute interest and premium or discount amortization (effective interest method), agree dividends to published declarations, recompute realized gains and losses on sales |
Exam Trap: A broker or custodian confirmation supports existence and rights, but not valuation. The auditor still needs separate evidence about fair value or credit losses.
3. Classification Judgments That Often Go Wrong
Held-to-maturity intent and ability. HTM classification requires the positive intent and ability to hold the security to maturity. If an entity sells a significant portion of its HTM portfolio for reasons outside the narrow exceptions in ASC 320 (such as to raise cash), the sale calls into question its intent to hold the remaining securities, and the auditor evaluates whether the rest should be reclassified. The auditor corroborates intent with the entity's liquidity forecasts, investment policy, and past behavior, and obtains written representations.
Significant influence. Owning 20% or more of voting stock creates a presumption of significant influence, but the evidence can overcome it (for example, when another shareholder controls the investee and the investor has no board seat). Board representation, participation in policy decisions, material intercompany transactions, and interchange of managers can show influence below 20%.
4. Equity-Method Investees and Valuations Based on Investee Results
Evidence about an equity-method investment depends heavily on the investee's financial information:
- Obtain and read the investee's financial statements and the report of the investee's auditor, if any. Consider whether that auditor is competent and independent and whether the report is satisfactory for the investor's purposes.
- Apply additional procedures when needed. If the investee's statements are unaudited, or the audit report is not satisfactory, the auditor performs or arranges procedures on the investee's financial information. Under extant AU-C 600, a significant equity-method investee may be a component of the group audit.
- Consider reporting lags. An investor may record its share using investee statements up to three months older than its own period end if it does so consistently; material intervening events still need recognition or disclosure.
- Test transactions between investor and investee and the elimination of intra-entity profits.
- Evaluate impairment indicators, such as sustained investee losses or a market value below carrying amount, for declines that are other than temporary.
5. Worked Scenario: Level 3 Private Equity Holding
A client holds a $6 million interest in a private company, valued by management with a discounted cash flow model (Level 3). Management assumes 12% annual revenue growth and a 9% discount rate. The investee's growth over the past three years averaged 4%, and a recent financing round sold similar shares at a price implying a value of about $4.8 million for the client's interest.
- Contradictory evidence: The observable transaction is evidence that contradicts management's model, and SAS No. 142 and AU-C 540 require the auditor to consider it.
- Assumption testing: The growth rate is three times the historical trend and needs support; the discount rate should reflect market participant risk for an illiquid private investment.
- Likely response: Develop an independent range with a valuation specialist, weigh the recent transaction heavily, and evaluate any difference between management's estimate and the auditor's range as a misstatement and a possible indicator of management bias.
A client's marketable securities are held by an independent bank custodian. Which procedure provides the most direct evidence that the securities exist at year-end?
A client classifies a portfolio of corporate bonds as held to maturity. During the year it sold about 40% of the portfolio to cover an operating cash shortfall. What should the auditor evaluate?
Management values a Level 3 private equity investment using its own discounted cash flow model. A recent financing round of the investee sold similar shares at a price implying a much lower value. What is the auditor's most appropriate response?
An investor owns 30% of an investee and accounts for it under the equity method. The investee's financial statements are audited by another CPA firm. Which evidence is most relevant to the investor's share of the investee's earnings?