A client's $24 million investments line is actually four audits in one: a Treasury ladder, a brokerage portfolio, a private equity fund interest, and a 30% equity-method stake. The exam will not ask whether you "audited investments." It will ask which assertion you were testing, what procedure fits that assertion at that level of the fair value hierarchy, and whether your evidence supports the carrying amount and its disclosure.
HIGH-FREQUENCY: Existence asks whether the investments on the books actually exist at the balance-sheet date. Two procedures dominate.
Confirmation with the custodian. When a broker, bank, or trustee holds the securities, the auditor sends a confirmation request directly to the custodian (not through the client), listing each security by CUSIP, par value, share count, and cost or fair value. The auditor controls the response and reconciles differences to the general ledger, testing management's conclusions about the recorded balance. AU-C 501 treats the custodian confirmation as the primary existence evidence for externally held securities.
Common mistakes
- Treating a client-provided broker statement as confirmation evidence. The exam will offer a fact pattern where management hands the auditor a brokerage statement and the auditor traces the GL to the statement. That is not external evidence under AU-C 505.
- Skipping rights testing because confirmation was clean. Confirmations show that the custodian holds securities in the entity's name. They do not show whether the securities are pledged, restricted, or held subject to a securities lending agreement.
- Applying Level 1 procedures to a Level 2 holding. Level 1 audit work is comparing the price to a quoted source. Level 2 requires evaluating the model, the inputs, and whether the inputs are genuinely observable.
Bottom line
- Existence is tested by confirmation with the custodian for securities held by a third party and physical inspection for certificates held by the entity; both at or near the balance-sheet date
- Rights and obligations require evidence of legal title, transfer restrictions, and whether securities are pledged or collateralized; confirmations and loan agreements are the primary sources
- Valuation turns on classification (held-to-maturity, available-for-sale, trading, equity method) and the fair value hierarchy (Level 1 quoted price, Level 2 observable inputs, Level 3 unobservable inputs); Level 3 carries the most audit risk
- Completeness means searching for unrecorded investments by reviewing broker statements, board minutes, dividend and interest income, and confirming zero balances at known custodians
Exam shortcut
When a question describes investments held by a third party, the answer almost always involves direct confirmation with the custodian. Reject any choice that has the auditor relying on a client-provided statement, and reject any choice that treats inquiry of management as primary existence evidence.
The full lesson (about 2,562 words, 17 min read) adds 1 worked example, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- III.E2
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