Chapter 23, Problem 24DQP

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. 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. 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. 3. The CEO makes the determination to classify securities as trading or available-for-sale.
4. 4. McNeil Co. has recorded significant gains on sales of financial instruments.
5. 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.

Required

1. a. Identify the inherent and control risks related to the financial instruments accounts for McNeil Co.
2. b. Identify at least two audit procedures the auditor would perform to test the existence balance-related audit objective for the trading and available-for-sale securities.
3. c. How would the auditor test the completeness balance-related audit objective for the speculative derivative financial instruments?
4. 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.
5. e. In your opinion, would the audit of financial instruments require the use of a valuation specialist? Why or why not?