Investment Companies Industry Developments 2007/08 - Audit Risk Alert

This Audit Risk Alert provides auditors of financial statements of investment companies with an overview of recent economic, industry, technical, regulatory, and professional developments that may affect audits and other engagements performed. This alert can also be used by an entity’s internal management to address areas of audit concern. This alert is an important tool in helping you identify the significant risks that may result in the material misstatement of financial statements. Moreover, this alert delivers information about emerging practice issues and current accounting and auditing developments that may affect all industries and all audit engagements.

This alert provides important regulatory updates including SEC regulations specific to investment companies. You will also find information on recently issued accounting and auditing standards such as:

• Fair Value Accounting Standards (FASB Nos. 157 and 159)
• SOP 07-1
• FIN 48
• Risk Assessment Standards
• SAS No. 112
• SAS No. 114

The alert covers emerging issues including:

• The ASB’s Clarity Project including convergence with international standards
• The FASB Codification Project
• Business Combinations

This publication is an other auditing publication as defined in AU section 150. Other auditing publications have no authoritative status; however, they may help the auditor understand and apply the Statements on Auditing Standards. The auditing guidance in this document has been reviewed by the AICPA Audit and Attest Standards staff and published by the AICPA and is presumed to be appropriate. This document has not been approved, disapproved, or otherwise acted on by a senior technical committee of the AICPA.

How This Alert Helps You

.01 This Audit Risk Alert (alert) helps you plan and perform your investment company audits. This alert can also be used by an entity's internal management to address areas of audit concern. This alert provides information to assist you in achieving a more robust understanding of the business,.24 economic, and regulatory environment in which your clients operate. This alert is an important tool in helping you identify the significant risks that may result. in the material misstatement of financial statements. Moreover, this alert delivers information about emerging practice issues and current accounting, auditing, and regulatory developments. .

02 This alert is intended to be used in conjunction with the AICPA Audit Risk Alert--2007/08 (product no. 022338kk). This alert can be obtained by calling the AICPA at (888) 777-7077 or going online to www.cpa2biz.com. You should refer to the full text of accounting and auditing pronouncements as well as the full text of any rules or publications that are discussed in this alert. .

03 References to Professional Standards. When referring to the professional standards, this alert cites the applicable sections as codified in the AICPA Professional Standards and not the numbered statements, as appropriate For example, Statement on Auditing Standards (SAS) No. 54, Illegal Acts by Clients, is referred to as AU section 317 of the AICPA Professional Standards.

Understanding the Entity and Its Environment and35 Assessing the Risks of Material Misstatement .

04 An auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risks of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures. An auditor's understanding of the entity and its environment consists of an understanding of the following aspects:

• Industry, regulatory, and other external factors
• Nature of the entity.
• Objectives and strategies and the related business risks that may result in a material misstatement of the financial statements
• Measurement and review of the entity's financial performance
• Internal control, which includes the selection and application of accounting policies

.05 The investment companies industry may be subject to specific risks of material misstatement arising from the nature of the business, the degree of regulation, or other external forces (for example, political, economic, social, technical, and competitive forces)

.06 The auditor should obtain an understanding of the entity's objectives and strategies, and the related business risks that may result in material misstatement of the financial statements. Business risks result from significant conditions, events, circumstances, actions, or inactions that could adversely affect the entity's ability to achieve its objectives and execute its strategies, or through the setting of inappropriate objectives and strategies. Just as the external environment changes, the conduct of the entity's business is also dynamic, ARA-INV .06 8 Audit Risk Alert and the entity's strategies and objectives change over time. An understanding of business risks increases the likelihood of identifying risks of material misstatement However, the auditor does not have a responsibility to identify or-.96 assess all business risks. Most business risks will eventually have financial consequences and, therefore, an effect on the financial statements. However, not all business risks give rise to risks of material misstatement.

.07 After obtaining a sufficient understanding of the entity and its environment, including its internal control, an auditor should identify and assess the risks of material misstatement at the financial statement level and at the relevant assertion level related to classes of transactions, account balances, and disclosures based on that understanding.

.08 Understanding and properly addressing, as necessary, the matters presented in this alert will help you gain a better understanding of your client's environment, better assess risks of material misstatement of the financial statements, and strengthen the integrity of your audits

Economic and Industry Developments
The State of the Economy

.09 When planning and performing audit engagements, an auditor should understand the economic conditions facing the industry in which the client operates. Economic activities relating to factors such as interest rates, consumer confidence, overall economic expansion or contraction, inflation, and labor market conditions are likely to have an impact on the entity's financial statements being audited

.10 The U.S. real gross domestic product (GDP), the broadest measure of economic activity, measures output of goods and services by labor and property within the United States and increases as the economy grows. According to the Bureau of Economic Analysis, GDP increased at an annual rate of 2.9 percent in 2006, consistent with the pace of growth experienced in 2005 when GDP increased by 3.1 percent. During the first quarter of 2007, GDP increased by an annual rate of only 0.6 percent. However, according to second quarter final estimates, GDP increased at an annual rate of 3.8 percent.

.11 The unemployment rate remained relatively unchanged during 2006, holding between 4.4 percent and 4.8 percent, with an annual average rate of 4.6 percent representing approximately 7 million people. The 2006 rates represent the lowest annual rate and total number of jobless since 2000, according to the U.S. Department of Labor, Bureau of Labor Statistics. During the first half of 2007, the unemployment rate averaged 4.5 percent. These data further demonstrate the economic growth the United States has experienced since the beginning of 2006.

.12 After a period of rising rates during the first half of 2006, the Federal Reserve kept its target for the federal funds rate at 5.25 percent for 10 consecutive meetings (June 2006-August 2007). At that time, the Federal Reserve indicated future federal fund rate adjustments would likely depend upon the outlook for economic growth and inflation. Since its August 2007 meeting and in response to shaky financial market conditions, the Federal Reserve has taken several action steps. It announced that it would provide reserves as necessary through the open market to facilitate the orderly functioning of financial markets by promoting trading in the federal funds market at rates close to the Investment Companies Industry Developments--2007/08 9 percent target rate. On August 17, 2007, it announced that financial market conditions had deteriorated and tighter credit conditions and increased uncertainty have the potential to restrain economic growth. Then, at its September meeting, the Federal Reserve decided to lower its target for the federal funds rate 50 basis points (bp) to 4.75 percent citing increased uncertainty surrounding the economic outlook. The Federal Reserve also decided to decrease the discount rate 50 bp to 5.25 percent to consistently keep the spread between the primary credit rate and the target federal funds rate at 50 bp. Auditors should remain alert to developments in the financial markets and how they may affect your audit engagements.

Industry Trends and Conditions
Subprime Trends and Events

.13 OnMay 17, 2007, Ben S. Bernanke, chairman of the Board of Governors of the Federal Reserve System, commented that the rise in delinquencies among subprime adjustable rate mortgages was due to several causes. These causes include rising interest rates, moderate economic growth, decline in the housing market, and regional economic problems.

.14 Bernanke noted that the practices of several mortgage originators to loosen underwriting standards contributed to the problems in the subprime market. As the underlying pace of mortgage originations slowed, the demand for securities with high-yield rates strengthened and some lenders loosened underwriting standards. The loosened standards undoubtedly contributed to defaults occurring within a few months of origination. Bernanke explained that mortgages sold generally pass a large amount of risk to the investor, rather than being borne primarily by the company that originated the loan, which may have contributed to the loosening of underwriting standards. In addition to weakened standards, incentive structures that tied originator revenue to the number of loans finalized, rather than the quality of loans made, are also a cause for concern.

.15 Despite subprime woes, Bernanke indicated that the market had shown signs of self-correction. While credit spreads on new subprime securities have risen, the volume of subprime-mortgage-backed securities issued has slowed. That does not mean, however, that the subprime market has evaporated. While some subprime lenders have gone out of business, other entities, such as hedge funds and investment banks, have started to purchase subprimemortgage- backed securities. Importantly, Bernanke pointed out that the majority of troubled lenders have not been institutions with federally maintained
deposits.