CASE STUDY

Here are some of the key operating aspects of Company:

Company has an investment committee which authorizes the amount of bonds and the dollar amount to be spent on all purchases.The investment committee also recommends the sales prices of the securities to outside customers.

Company has a separate trader that purchases the bonds from the underwriters, based on the authorization from the investment committee.

The inventory group accepts these purchases into the trading inventory of the entity at the initial purchase price.

The inventory group determines fair values from a feed from an investment pricing service.The pricing service utilizes market data to include quoted prices, the financial condition of the issuer, credit rating of the issuer, the interest rate of the bonds and any credit enhancement features.

Company also utilizes its proprietary software to account for all purchases, valuations and sales of municipal bonds.

The sales force receives the daily list of inventory, the fair values and the recommended sales prices.

The sales force is compensated on a combined salary and commission basis.

Sales that are completed by a sales representative are confirmed by a settlement group within Company and the sales are executed and paid for within three days under normal settlement terms.

At the end of any given day, Company will hold securities in 15 to 20 different entities which have to be measured using fair value for accounting purposes.

The accounting department tests the fair value of a portion (anywhere from 25% to 50%) of the positions at the end of each month by requesting fair value quotes from other market sources, such as independent brokers and stock exchanges, and comparing the fair value amounts to those provided by the investment pricing service.

Occasional adjustments are proposed by the accounting department based on quotes from other sources to arrive at fair value amounts used for financial reporting purposes.

As the senior external auditor for Company, you are preparing your interim review of the processes and controls and initial risk assessment for the municipal bond portfolio.Subsequent to that, you will develop your preliminary audit strategy and procedures. The partner has asked you for a preliminary set of procedures that you believe should be undertaken.The purpose of the initial set of procedures is to estimate the fees that may be incurred in auditing the bond portfolio.Since this is the largest component of the balance sheet, the partner wants to make certain that this estimate is as accurate as possible so it can be reflected in the total estimated audit fees.

Required

Prepare the audit strategy and procedures (no more than two pages) you believe make sense in auditing the fair value measures of the municipal bond portfolio of Smith and Stanley given the controls that are in place.

This is the our answer.

What should we need to add?

Smith and Stanley specialize in the buying and selling of municipal bonds. They tend to buy these bonds from large banks and sell them to smaller institutions (banks, mutual funds, etc.). The company seems to have competent internal controls which include separation of duties, committees to determine prices, and adjustments made based on quotes from multiple sources. Assets mostly consist of municipal bonds ($50 million out of $60 million).

One would assume a large entity that trades across many markets daily would have high quality internal controls and would be able to estimate fair value with competent people. Additionally, their risk management programs should be capable to effectively mitigate and assess risk. With these facts, the company would most likely be assuming fair value using multiple reliable models to ensure a reliable fair value estimate. It is likely appropriate to audit fair value measurements by testing the entity's procedures and controls of determining fair value.

Smith and Company does not have an entity related specialist to determine the fair value. The company specializes in municipal bonds and trades then regularly. With being such a large company, it is expected that they have people in house that can estimate the fair value of these bonds. Due to this, one way to audit the work is by observing and testing the methods and data used to estimate fair value.