CFSA Study Guide

Certified Financial Services Auditor ExaminationCFSA Study Guide Albert J. Marcella Jr., Ph.D., CFSA, COAP, CSP, CQA, CDP, CISA William J. Sampias, CFSA, CISA James K. Kincaid, CFSA 2 Reviewers and Contributors The authors wish to acknowledge the Institute of Internal Auditors, the Information Systems Audit and Control Association, the National Association of Certified Financial Services Auditors, and the American Institute of Certified Public Accountants for permission to quote extensively from Standards for the Professional Practice of Internal Auditing, Statements on Auditing Standards, Control Objectives for Information and related Technology, and Codes of Professional Ethics, and other publications. The willingness of these professional bodies to permit use of these materials contributed greatly to the development of this study guide series. Additionally, the following individuals were instrumental in providing evaluation, constructive feedback and suggestions for improvement, to these professionals we are also indebted to: Michael I. Balbirnie, Senior Vice President, First Union Corp Robert J. McNichols, Director of Internal Audit, Penn National Insurance Bruce Monahan, Vice President/Director of Internal Audit, GRE Insurance Group Dedication Special thanks go to our families, spouses, parents, and children, whose continuing support, love, and patience has been a source of strength and motivation. With heartfelt thanks, AJM WJS JKK 2 3 About the Authors Albert J. Marcella, Jr. Ph.D., CFSA, COAP, CQA, CSP, CDP, CISA, is an Associate Professor of Management in the School of Business and Technology, Department of Management, at Webster University, in Saint Louis, MO. Dr. Marcella remains the president of Business Automation Consultants, an information technology and management-consulting firm. He has contributed numerous articles to audit related publications and has authored and co-authored 15 audit related texts. Dr. Marcella, holds a Ph.D. in Management with emphasis in Information Technology from Walden University in Minneapolis, a Masters of Business Administration in Finance, from The University of New Haven in Connecticut, and a Bachelor of Science degree in Business Administration with a dual major in Management Information Systems and Management from Bryant College in Rhode Island. William J. Sampias, CFSA, CISA, has been involved in the auditing profession for the last decade with a primary emphasis on audits of information systems. Mr. Sampias has published several works in the areas of disaster contingency planning, end-user computing, fraud, effective communications, and security awareness. Mr. Sampias is currently Director of an Information Systems Audit group. He holds an MBA from the University of Illinois at Springfield. James K. Kincaid, CFSA, has over 15 years experience conducting and managing audits to assess the effectiveness of government programs and operations. Prior to entering the government auditing field, Mr. Kincaid worked in the insurance industry. He is the co-author of several books, articles, and training courses on topics such as fraud auditing, business ethics, writing skills, and computers. In addition to auditing, Mr. Kincaid has served as an adjunct instructor at Lincoln Land Community College. He has also taught many audit training courses and spoken at several audit conferences. He holds a Master of Arts degree in English and an MBA from the University of Illinois at Springfield. . 3 4 Please contact the following to obtain additional information on obtaining copies of this Study Guide: The Institute of Internal Auditors C.S. 1616 Alpharetta GA 30009-1616 +1-877-867-4957 (toll free in the U.S. and Canada) or +1-770-442-8633 ext. 275 email: [email protected] online: www.theiia.org Copyright 2000. All rights reserved. No part of this work may be used or reproduced in any manner whatsoever, including but not limited to electronic medium, without express written permission from The IIA. 4 5 CFSA Study Guide Table of Contents Preface Special Notice Core Competencies for Financial Services Auditors Recommended Review Materials Internet Resources Preparing to Pass the CFSA Examination Core Competency Number One: Auditing Unit 1 - Audit Standards A. Institute of Internal Auditors (IIA) Standards B. Introduction to IIA Standards C. Text of the IIA Standards D. AICPA Statements on Auditing Standards Overview of SAS 65 Overview of SAS 70 E. CFSA Code of Professional Ethics Unit 2 - Internal Audit Organization A. Audit Charter B. Reporting Responsibility C. Audit Committee Unit 3 - Internal Control A. IIA Standards for Internal Control B. Summary of AICPA Standards for Internal Control C. Elements and Types of Internal Control D. Evaluation of the System of Internal Control E. Internal Control Integrated Framework (COSO) F. Control Self Assessment Unit 4 - Audit Process I. Audit Planning A. IIA Standards for Audit Planning B. AICPA Standards for Planning Audits that Involve Computers II. Audit Programs A. IIA Standards for Writing Audit Programs B. Functions of Audit Programs C. Contents of Audit Programs III. Audit Workpapers 5 6 A. IIA Standards for Workpapers B. Purposes of Workpapers C. Basic Workpaper Guidelines D. Types of Information Typically Contained in Workpapers E. The Role of Workpapers in Audit Supervision IV. Audit Evidence A. IIA Standards for Audit Evidence B. Use of Evidence to Support Audit Findings C Types of Evidence D. Unsupported Allegations E. Adequacy of Audit Evidence V. Review and Evaluation of Findings A. IIA Standards for Review and Evaluation of Findings B. Additional Guidelines for the review and Evaluation of Findings VI. Audit Reports A. IIA Standards for Audit Reports B. Additional Guidelines for Audit Reports VII. Permanent Files A. IIA Standards for Permanent Files B. Types of Information Typically Contained in Permanent Files Unit 5 - Audit Techniques I. Risk Assessment A. IIA Standards for Risk Assessment B. AICPA Standards for Audit Risk C. Overview of SAS 47 D. Overview of SAS 82 E. Types of Audit Risk F. Methodology for Evaluating Audit Risk G. Documentation of Risk Assessment II. Analytical Review A. IIA Standards for Analytical Reviews B. AICPA Procedures for Analytical Procedures C. Benefits of Analytical Reviews D. Types of Analytical Reviews III. Statistical Sampling A. AICPA Standards for Audit Sampling B. Basic Steps for Developing a Statistical Sample C. Variables Affecting Sample Size D. Variables Sampling E. Attribute Sampling IV. Flowcharting A. Flowcharting B. Narratives C Questionnaires V. Confirmations A. AICPA Standards on Confirmations 6 Separation of Processing and Development E. Reconciliation of Input to Output F. Audit Tools L. Other Services/Operations A. Branch Operations D. Retained Earings G.7 B. Premises and Equipment I. Authorization of Transactions H. Physical and Data Security Access Controls I. Other Borrowed Funds D. Cash and Due From Banks B. Long-Term Debt E. Automated Administrative Procedures Core Competency Number Two: Banking Industry Unit 1 – Financial Statement Applications I. Business Risk Planning K. Interest Bearing Accounts D. Trading Securities E. Compliance and Substantive Testing A. Securities Available for Resale F. Loans G. Liabilities and Shareholders’ Equity A. Substantive Testing Unit 6 . Other Assets II. Deposits B. Control of Data Files G. Compliance Testing B. Internal Control Development B.Information Systems Auditing A. Trust 7 . Automated Clearing House and Wire Transfer C. Preferred/Common Stock F. Segregation of Duties D. End-User Computing . Customer Acceptance (Letters of Credit) E. Assets A. Input/Processing/Output Controls C. Payroll/Employee Benefits B. Allowance for Loan Losses H. Intangible Assets F. Securities Sold Under Repurchase Agreements and Federal Funds Purchased C. Common Ways Auditors Use Confirmations VI. Treasury Stock III.Including Microcomputers J. Federal Funds Sold and Securities Purchased Under Resale C. The Stock Exchanges D. The McCarran Ferguson Act B. Risk Management J. Sales. Asset/Liability Management G. Use of Derivatives H. Overview B. Statement of Cash Flows IV. Life.8 E. Claims F. Administration Unit 2 – Laws and Regulations A. Reinsurance D. Compliance H. Overview of the Regulatory Environment B. Financial Reporting G. and Distribution B. Underwriting C. Premium Audit H. The National Association of Insurance Commissioners (NAIC) D. Effect of Interest Rate Movements D. The Securities and Exchange Commission E. Acturial E. Laws and Regulations Core Competency Number Three: Insurance Industry Unit 1 – Applications/Processes A. New Issues A. Investment Operations I. Property and Casualty Products Core Competency Number Four: Securities Industry Unit 1 – Financial Markets A. Preferred Stock 8 . Marketing. Monetary Management Theories Unit 2 – Laws/Regulations and Regulatory Environment A. State Model Laws Unit 3 – Products A. Bond and Stock Markets C. Money and Banking A. and Annuity B. Pension. Common Stock B. State Insurance Commissions C. Options Market Unit 2 – Equities. Investment Products F. Role of Money and Banking B. Debt Securities. Over-The-Counter Market E. Employment Retirement Income Security Act (ERISA) F. Options. Unit Investment Trusts (UIT’s) B. Specialized Funds Unit 4 – Investment Trusts A. Debt Securities E. Income Mutual Funds C. Investment Company Act and Advisors Act of 1940 D. Securities Act of 1933 B. Real Estate Investment Trusts (REIT’s) Unit 5. Options Unit 3 – Mutual Funds A. Growth Mutual Funds E. Stock Funds D. Comments or Corrections Concerning the CFSA Study Guide Appendix B. National Association of Securities Dealers Rules E. Margin Lending Appendix A. Municipal Securities Rule Making Board F. Balanced Funds F.Study Question Answers 9 .9 C. Basic Concepts B.Regulations A. Securities Exchange Act of 1934 C. Warrants D.Questions. comments. However. 10 . as it will help us improve future editions of the Guide. We appreciate any feedback. The Guide provides a general overview of the topics that will be covered in the exam. The last page of the book has been designed to facilitate your notation of corrections and comments. it is critical that you perform additional study in areas where your experience or background dictates the need for additional review. Good luck on the CFSA Exam. Please feel free to submit your questions.10 Preface The purpose of this Study Guide is to help you prepare to pass the Certified Financial Services Auditor (CFSA) Examination. A list of resource materials is included to provide additional resources to supplement your study. or corrections concerning the Guide to the authors. visit Certifications on The IIA web site. For more information. The IIA is modifying the exam slightly by offering it in a one-part format. THE IIA WILL OFFER A PILOT OF THE REVISED CERTIFIED FINANCIAL SERVICES AUDITOR (CFSA) exam on November 21. The CFSA designation was launched a few years ago by NAFSA. 2002 at IIA examination sites throughout the United States. The 150-question pilot will test candidates’ knowledge on financial services auditing. 11 . twice annually. This guide is intended for use as study material for the November 2002 CFSA pilot exam. The CFSA demonstrates competency in financial-services audit practices and methodologies. similar to other IIA specialty examinations. and securities. insurance.11 SPECIAL NOTICE The IIA assumed management of the CFSA during a merger with the National Association of Financial Services Auditors (NAFSA) in June 2002. who offered it as a four-part examination. banking. 12 Core Competencies for Financial Services Auditors The Core Competencies for Financial Services Auditors. Audit Committee C. A. the Insurance industry and the Securities Industry are used as a basis for construction of the Certified Financial Services Auditor's examination. Independence b. Internal Control 1. AICPA Statements on Auditing Standards (SAS's) (emphasis on #65 & #70) 3. the Banking industry. Professional Proficiency c. Internal Audit Organization 1. 4. Elements and Types Evaluation of the System of Internal Control Internal Control Integrated Framework (COSO) Control Self Assessment 12 . IIA Standards a. This Study Guide is designed around the core competencies listed in the following section. Management of the Internal Audit Department 2. 3. Scope of Work d. The Core Competencies are included below. CFSA Code of Ethics B. Performance of Audit Work e. Each of the items listed below is addressed in the CFSA Study Guide. in the fields of Audit. Auditing Brokerage Financial Institutions Insurance Auditing Audit Standards 1. 2. • • • • I. Reporting Responsibility 3. Audit Charter 2. 2. Control of Data Files 7. 6. Narratives and Questionnaires Confirmations Compliance and Substantive Testing F. 6. Business Risk Planning 11. Audit Planning Audit Programs Audit Workpapers Audit Evidence Review and Evaluation of Findings Audit Reports Audit Workpapers Permanent Files E. End-User Computing . Authorization of Transactions 8. 2. Mainframes. Internal Control Development 2. WANs. Risk Assessment Analytical Review Statistical Sampling Flowcharting. Audit Tools a. 4. 5. Reconciliation of Input to Output 6. 3. 7. Segregation of Duties 4. Computer Assisted Auditing Techniques b. Audit Process 1. 3. 4. Input/Processing/Output Controls 3.Including Microcomputers 10. Physical and Data Security Access Control 9. Audit Techniques 1. 5. Separation of Processing and Development 5. Microcomputers) 1. Information Systems Auditing (LANs. Automated Administrative Processes 13 .13 D. 8. Assets a. Loans Held for Sale g. Interest Bearing III. Time b. Other Assets 2. Deposits I. Allowance for Loan Losses i. Interest Bearing Accounts d. Loans I. Customer Acceptances (Letters of Credit) k. Leasing Companies. International h. Retained Earnings h. Cash and Due from Banks b. Credit Unions. Liabilities and Shareholders Equity a. Other Borrowed Funds e. Mortgage Bankers) A. Commercial II. Federal Funds Sold and Securities Purchased under Resale Agreements c. Savings Banks. Other Real Estate Owned m. Preferred/Common Stock g. Residential III. Leases V. Treasury Stock 14 . Federal Funds Purchased d. Intangible Assets l. Finance Companies. Credit Card VI. Securities Sold under Repurchase Agreements c. Trust Companies. Credit Card Companies.14 II. Long Term Debt f. Securities Available for Sale f. Trading Securities e. Banking Industry (Commercial Banks. Consumer IV. Financial Statement Application 1. Premises and Equipment j. Non Interest Bearing II. Savings IV. Loans to Executive Officers Reg P/Reg 21.Bank Holding Company Act Reg Z . Transfer/Registrar e.Collection of Checks and other Items Reg K . ACH/Wire Transfer c.Reserve Requirements Reg E .Edge Act Reg L . right of rescission. restitution) 15 . Asset/Liability Management g.Credit by Banks for Purchase of Margin Stocks Reg Y .Bank Protection Act Reg Q . home equity.15 3. Federal Reserve System b.Equal Credit Opportunity Act Reg C . Monetary Management Theories B. Investment Products f. Interlocks Act Reg M . FDIC d. Effect of Interest Rate Movements d. NCUA 2. closed end. Other Services/Operations a. Money & Banking a. Laws/Regulations and Regulatory Environment 1. State Regulatory Systems e. Office of the Comptroller of the Currency c. Employee Benefit IV. Payroll/Employee Benefits b.Consumer Leasing Reg O . Personal II. Laws and Regulations Reg A .Depository Institution Man. Bond and Stock Markets c. Overview of the Regulatory Environment a.Borrowing by Depository Institutions Reg B . Branch Operations d.Electronic Funds Transfer Act Reg J .Interest on Deposits Reg U . Use of Derivatives h. Trust I. Statement of Cash Flows 4. Role of Money and Banking b. credit cards.Home Mortgage Disclosure Act Reg D .Truth in Lending (open end. Corporate III. Availability of Funds and Collection of Checks Reg DD .FRB Sections 23 A&B Trust . Actuarial 5. The Securities and Exchange Commission 5. ERISA 6. The NAIC 4. Compliance 8. Marketing. Investment Operations 9. 16 .16 Reg BB . Underwriting 3. State Model Laws B.Real Estate Lending and Appraisals Bank Bribery Act Bank Secrecy Act Fair Credit Reporting Act Fair Debt Collection Practices Act Fair Housing Act Financial Institution Reform.12 CFR Part 9 III. Risk Management 10. Administration Laws and Regulations 1. Applications/processes 1. Claims 6. Premium Audit 11. Reinsurance 4. Recovery and Enforcement Act (FIRREA) FDIC Bank Improvement Act of 1991 Foreign Corrupt Practices Act National Flood Insurance Program OFAC Real Estate Settlement Procedures Act Right to Financial Privacy Act Tax Identification Reporting (TIN Compliance) Transactions with Affiliates .Community Reinvestment Act Reg CC . Insurance Industry A. Sales and Distribution 2.Truth in Savings Reg 34 . The McCarran Ferguson Act 2. State Insurance Commissions 3. Financial Reporting 7. Financial Guarantees g. Individual Insurance I. Administrative Service Only c. Qualified Plans II. HMO's VII. Accident and Health III. Plan Discrimination V. Endowments b. Whole Life II. Term Life III. Pension and Annuity a. Disability V.17 C. Workers Compensation b. Reinsurance 2. Variable Annuities d. General Liability c. Utilization Management IX. Fiduciaries VIII. Other 17 . Life. Vesting VII. Universal Life IV. Annuity X. Preferred Provider Organizations X. Group Insurance I. Savings Plans VI. Property and Casualty Products a. Managed Care VIII. Products 1. Qualification Rules IV. Pensions I. Dental VI. Prohibited Transactions IX. Homeowners e. Umbrella Coverage f. Life II. Fixed Annuities XI. Accidental Death and Dismemberment IV. Automobile d. Tax Favored Individual Retirement Plans III. Securities Industry (Broker Dealers. Over-The-Counter (OTC) Market a. Debt Securities a. Types of orders d. Terms and definitions 4. Listing and delisting rules c. Money market debt e. Listing and delisting rules c. Warrants a.18 IV. Government debt c. Common Stock a. Terms and definitions b. Financial Markets 1. Preferred Stock a. Debt Securities. Options markets a. New Issues 1. U. Overview a. How the option markets function B. The consolidated tape d. Equities. Municipal debt d. Specific rules relating to the NYSE e. Types of markets c. Bond ratings 18 . The Stock Exchanges a. How the OTC functions b. Corporate debt b. OTC rules 4. Effect of Interest Rates on Bond prices g. Options. New issues e. How the exchanges function b. Full Service/Discount Brokers. Regional stock exchanges 3.S. Investment Bankers) A. Clearing and Settlement process 2. Eurodollar debt f. Terms and definitions b. Preferred stock prices and features 3. Rights of common shareholders 2. Brokers and Dealers b. Mutual Funds 1. Investment Company Act and Advisors Act of 1940 3. Trading and Market rules d. Balanced Funds 5. Conduct of Customer Account rules c. Index options c. Stock Funds 3. Income Mutual Funds 2. Municipal Securities Rule Making Board a. National Association of Securities Dealers Rules a. Communications with the Public 4. Advertising and other rules 5. Margin Lending D. Equity options b. Interest Rate and Foreign Currency Options d. Financial Listings C. 19 . Variable Annuities 2. Fixed Annuities b. Growth Mutual Funds 4. Real Estate Investment Trusts (REIT's) E. Trading and Market rules d. Options a. Conduct of Customer Account rules c. Specialized Funds Annuities 1. Registered Representative rules b. Securities and Exchange Acts of 1933/1934 2.19 5. Unit Investment Trusts (UIT's) a. Options Clearing Corp rules e. Regulations 1. Registered Representative rules b. 20 Certified Financial Services Auditor Program Recommended Review Materials Audit Standards for the Professional Practice of Internal Auditing Institute of Internal Auditors 247 Maitland Avenue Altamonte Springs. NJ 07311-3881 (800) 862-4272 Brokerage Introduction to Brokerage Operations Department Procedures New York Institute of Finance ISBN 0-13-478975-X (212) 859-5000 Audits of Investment Companies AICPA P. FL 32701-4201 Phone # (407) 937-1100 www. NY 10256-9264 (800) 862-4272 Financial Institutions AICPA Audit & Accounting Guide for Banks and Savings Institutions AICPA Kenneth J. Box 9264 Church Street Station New York. O. Namjestnik Trust Audit Manual Bank Administration Institute Rolling Meadows. IL 60008-4097 (800) 323-8552 20 .Integrated Framework AICPA Harborside Financial Center 201 Plaza Three Jersey City.org/ COSO Internal Control .theiia. theiia. Inc. Long.Life Management Institute. 1996 Information Systems Audit and Control Association and Foundation http://www. Life.0716 (800) 644-2101 21 .Life Management Institute. Health & Annuities (LOMA .htm Insurance Kenneth Huggins & Robert D.21 The Price Waterhouse Compliance Series IRWIN Professional Publishing Chicago 1996 IS Audit Control Objectives for Information and Related Technology (Cobit). PO Box 930108 Atlanta. PA 19355. Smith & Erica Wiening How Insurance Works 2nd Edition 1994 Insurance Institute of America 720 Providence Road Malvern. March 1996) c/o PBD. 1996) c/o PBD.org/cobit. Jones & Dani L. Georgia 31193 (770) 442-8631 Harriett E.isaca. Georgia 31193 (770) 442-8631 Barry D. Principles of Insurance. PO Box 930108 Atlanta. Land. Operations of Life and Health Insurance Companies 2nd Edition (LOMA .htm or Systems Auditablity and Control Institute of Internal Auditors http://www. Inc.org/tech/sacrep. com www.iitf.gov Bankinfo.org/ IT Audit Forum www.org/ Information Systems Audit and Control Association (ISACA) www.22 Internet Resources National Association of Financial Services Auditors (NAFSA) www.gov/ American Institute of Certified Public Accountants (AICPA) www.auditnet.org/ Information Infrastructure Task Force www.treas.federalreserve.access.theiia.fdic.gov/general.itaudit.com/ The Institute of Internal Auditors (IIA) www.htm Association of Certified Fraud Auditors www.cfenet.org Federal Reserve System www.gpo.gov Federal Deposit Insurance Corporation www.htm Office of the Comptroller of the Currency www.occ.com Auditnet www.com 22 .org/index.bankinfo.gov Code of Federal Regulations www.nafsa.isaca.aicpa.nist. Dress comfortably. Find a suitable place to study. The number of correct answers determines your final score on the CFSA examination. 5. 7. So guessing is better than not answering a question at all 23 . there is no penalty for providing a wrong answer. 3. 6. Test Taking Tips 1. A list of supplemental books and materials is provided in this study guide. Read answer choices carefully. Secure the proper study materials. 4. Answer all questions. Familiarize yourself with the exam site and surrounding facilities. then go back and spend the remainder of the available time working on the other questions. Read the entire question slowly and carefully before attempting to answer it. Begin preparing well in advance of the test date. 4. Budget your time. 3. 2. Therefore. Answer the questions in which you are certain of the answer first. 5. Arrive at the exam site in plenty of time before the test begins. Relax and get plenty of sleep the night before the test.23 Preparing to Pass the CFSA Examination 1. 2. 24 VOLUME I AUDITING 24 . The IIA serves more than 60. the IIA standards were in the process of being modified. Standards establish the basic principles and guidance to assist auditors in the performance of their duties. The world's leader in certification. The principles establish the framework to promote the credibility of the auditor’s work product. "Progress Through Sharing. most of the information in this Unit pertains to Standards that existed prior to changes made in June 1999 and beyond. certifying qualified auditing professionals. Introduction to IIA Standards As this study guide was being developed. Presenting important conferences and seminars for professional development. boards of directors and audit committees with standards. The history of internal auditing has been synonymous with that of The IIA and its motto. and conducting valuable research projects through The IIA Research Foundation are just a few of The Institute's many activities. The Institute serves as the profession's watchdog and resource on significant auditing issues around the globe. education. A. executive management. guidance. producing leadingedge educational products. Institute of Internal Auditors (IIA) Standards Established in 1941. governance and internal control. Since all of the Standards have not been updated. and information on internal auditing best practices. Information Technology (IT) audit.000 members in internal auditing. i UNIT 1: AUDIT STANDARDS Audit standards help define the role and responsibilities of auditors to internal and external entities. The IIA also provides internal auditing practitioners. The Institute is a dynamic international organization that meets the needs of a worldwide body of internal auditors. education. research.25 CORE COMPETENCY NUMBER ONE: AUDITING A general definition of auditing is the systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users. New 1999 Definition of Internal Auditing 25 . and technological guidance for the profession." ii B. providing quality assurance reviews and benchmarking. and security from more than 100 countries. appraisals. The Professional Practices Framework consists of the following components: Definition of Internal Auditing: Internal auditing is an independent. 2000.htm for more information. approved by senior management 26 . As a coherent system. and governance processes The IIA is also proposing changes to other standards. The information furnished to each may differ in format and detail. it facilitates consistent development. counsel. control. internal auditing furnishes them with analyses. authority. recommendations. and application of concepts.org/standard/standard. and techniques useful to a discipline or profession. An exposure draft of revision of the Attribute and Performance Standards was available for public comment from December 1. go to: http://www. 1999 through February 29. and responsibility (charter) for the internal auditing department.theiia. The audit objective includes promoting effective control at reasonable cost. It helps an organization accomplish its objectives by bringing a systematic. the overall purpose of the PPF is to organize the full range of existing and developing practice guidance in a manner that is readily accessible on a timely basis to internal auditors. In general. The statement of purpose. Internal auditors owe a responsibility to both. Information on the new standards was taken from the IIA web site. To this end. depending upon the requirements and requests of management and the board. disciplined approach to evaluate and improve the effectiveness of risk management. Specifically. 2000.26 The Professional Practices Framework (PPF) and Definition of Internal Auditing were approved by The IIA's Board of Directors in June 1999. providing them with information about the adequacy and effectiveness of the organization’s system of internal control and the quality of performance. methodologies. Introduction to IIA Standards (prior to June 1999) iii Internal auditing is an independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization. interpretation. 1999 through January 15. objective assurance and consulting activity designed to add value and improve an organization's operations. The internal auditing department is an integral part of the organization and functions under the policies established by senior management and the board. the PPF is intended to assist practitioners in being responsive to the expanding market for high quality internal auditing services. a framework provides a structural blueprint of how a body of knowledge and guidance fits together. An exposure draft of revision of the Code of Ethics was available for public comment from October 1. By encompassing current internal auditing practice as well as leading future expansion. The members of the organization assisted by internal auditing include those in management and the board. and information concerning the activities reviewed. The objective of internal auditing is to assist members of the organization in the effective discharge of their responsibilities. 27 and accepted by the board, should be consistent with these Standards for the Professional Practice of Internal Auditing. The charter should make clear the purposes of the internal auditing department, specify the unrestricted scope of its work, and declare that auditors are to have no authority or responsibility for the activities they audit. Throughout the world internal auditing is performed in diverse environments and within organizations that vary in purpose, size, and structure. In addition, the laws and customs within various countries differ from one another. These differences may affect the practice of internal auditing in each environment. The implementation of these Standards, therefore, will be governed by the environment in which the internal auditing department carries out its assigned responsibilities. Compliance with the concepts enunciated by the Standards is essential before the responsibilities of internal auditors can be met. As stated in the Code of Ethics, Members of The Institute of Internal Auditors and Certified Internal Auditors shall adopt suitable means to comply with the Standards. Independence, as used in the Standards, requires clarification. Internal auditors should be independent of the activities they audit. Such independence permits internal auditors to perform their work freely and objectively. Without independence, the desired results of internal auditing cannot be realized. In establishing the Standards, the following matters were considered: 1. Boards of directors are being held accountable for the adequacy and effectiveness of their organizations’ systems of internal control and quality of performance. 2. Members of management are relying upon internal auditing as a means of supplying objective analyses, appraisals, recommendations, counsel, and information on the organization’s controls and performance. 3. External auditors are using the results of internal audits to complement their own work where the internal auditors have provided suitable evidence of independence and adequate, professional audit work. In the light of such matters, the purposes of the Standards are to: 1. Impart an understanding of the role and responsibilities of internal auditing to all levels of management, boards of directors, public bodies, external auditors, and related professional organizations. 2. Establish the basis for the guidance and measurement of internal auditing performance. 3. Improve the practice of internal auditing. The Standards differentiate among the varied responsibilities of the organization, the internal auditing department, the director of internal auditing, and internal auditors. 27 28 The Standards encompass: Section 100: The independence of the internal auditing department from the activities audited and the objectivity of internal auditors. Section 200: The proficiency of internal auditors and the professional care they should exercise. Section 300: The scope of internal auditing work. Section 400: The performance of internal auditing assignments. Section 500: The management of the internal auditing department. C. Text of the IIA Standards The complete text of sections 100 and 200, and parts of section 500, are printed below. Sections 300 and 400 and the remainder of section 500 are printed later in this discussion of auditing. 100 INDEPENDENCE INTERNAL AUDITORS SHOULD BE INDEPENDENT OF THE ACTIVITIES THEY AUDIT. 01. Internal auditors are independent when they can carry out their work freely and objectively. Independence permits internal auditors to render the impartial and unbiased judgments essential to the proper conduct of audits. It is achieved through organizational status and objectivity. 110 Organizational Status The organizational status of the internal auditing department should be sufficient to permit the accomplishment of its audit responsibilities. 01.Internal auditors should have the support of senior management and of the board so that they can gain the cooperation of auditees and perform their work free from interference. 1. The director of the internal auditing department should be responsible to an individual in the organization with sufficient authority to promote independence and to ensure broad audit coverage, adequate consideration of audit reports, and appropriate action on audit recommendations. 2. The director should have direct communication with the board. Regular communication with the board helps assure independence and provides a means for the board and the director to keep each other informed on matters of mutual interest. a. Direct communication occurs when the director regularly attends and participates in those meetings of the board which relate to its oversight responsibilities for auditing, financial reporting, organizational governance and control. The director’s attendance at these meetings and the presentation of written and/or oral reports provides for an exchange of information concerning the plans and activities of the internal auditing department. The director of internal auditing should meet privately with the board at least annually. 28 29 3. Independence is enhanced when the board concurs in the appointment or removal of the director of the internal auditing department. 4. The purpose, authority, and responsibility of the internal auditing department should be defined in a formal written document (charter). The director should seek approval of the charter by senior management as well as acceptance by the board. The charter should (a) establish the department’s position within the organization; (b) authorize access to records, personnel, and physical properties relevant to the performance of audits; and (c) define the scope of internal auditing activities. a. The director of internal auditing should periodically assess whether the purpose, authority, and responsibility, as defined in the charter, continue to be adequate to enable the internal auditing department to accomplish its objectives. The result of this periodic assessment should be communicated to senior management and the board. 5. The director of internal auditing should submit annually to senior management for approval and to the board for its information a summary of the department’s audit work schedule, staffing plan, and financial budget. The director should also submit all significant interim changes for approval and information. Audit work schedules, staffing plans, and financial budgets should inform senior management and the board of the scope of internal auditing work and of any limitations placed on that scope. a. The approved audit work schedule, staffing plan, and financial budget, along with all significant interim changes, should contain sufficient information to enable the board to ascertain whether the internal auditing department’s objectives and plans support those of the organization and the board. This information should be communicated, preferably in writing. b. A scope limitation is a restriction placed upon the internal auditing department that precludes the department from accomplishing its objectives and plans. Among other things, a scope limitation may restrict the: • Scope defined in the charter. • Department’s access to records, personnel, and physical properties relevant to the performance of audits. • Approved audit work schedule. • Performance of necessary auditing procedures. • Approved staffing plan and financial budget. c. A scope limitation along with its potential effect should be communicated, preferably in writing, to the board. d. The director of internal auditing should consider whether it is appropriate to inform the board regarding scope limitations which were previously communicated to and accepted by the board. This may be necessary particularly when there have been organization, board, senior management, or other changes. 6. The director of internal auditing should submit activity reports to senior management and to the board annually or more frequently as necessary. Activity reports should highlight significant audit findings and recommendations and should inform senior management and the board of any significant deviations from approved audit work schedules, staffing plans, and financial budgets, and the reasons for them. a. Activity reports should be communicated, preferably in writing. 29 30 b. Significant audit findings are those conditions which, in the judgment of the director of internal auditing, could adversely affect the organization. Significant audit findings may include conditions dealing with irregularities, illegal acts, errors, inefficiency, waste, ineffectiveness, conflicts of interest, and control weaknesses. After reviewing such findings with senior management, the director of internal auditing should communicate significant audit findings to the board, whether or not they have been satisfactorily resolved. c. Management’s responsibility is to make decisions on the appropriate action to be taken regarding significant audit findings. Senior management may decide to assume the risk of not correcting the reported condition because of cost or other considerations. The board should be informed of senior management’s decision on all significant audit findings. d. The director of internal auditing should consider whether it is appropriate to inform the board regarding previously reported, significant audit findings in those instances when senior management and the board assumed the risk of not correcting the reported condition. This may be necessary, particularly when there have been organization, board, senior management, or other changes. e. The reasons for significant deviations from approved audit work schedules, staffing plans, and financial budgets that may require explanation include: • • • • • • Organization and management changes. Economic conditions. Legal and regulatory requirements. Internal auditing staff changes. Management requests. Expansion or reduction of audit scope as determined by the director of internal auditing. 120 Objectivity Internal auditors should be objective in performing audits. 01. Objectivity is an independent mental attitude which internal auditors should maintain in performing audits. Internal auditors are not to subordinate their judgment on audit matters to that of others. 02. Objectivity requires internal auditors to perform audits in such a manner that they have an honest belief in their work product and that no significant quality compromises are made. Internal auditors are not to be placed in situations in which they feel unable to make objective professional judgments. 1. Staff assignments should be made so that potential and actual conflicts of interest and bias are avoided. The director should periodically obtain from the internal auditing staff information concerning potential conflicts of interest and bias. 2. Internal auditors should report to the director any situations in which a conflict of interest or bias is present or may reasonably be inferred. The director should then reassign such auditors. 3. Staff assignments of internal auditors should be rotated periodically whenever it is practicable to do so. 4. Internal auditors should not assume operating responsibilities. But if on occasion senior management directs internal auditors to perform nonaudit work, it should be understood that they are not functioning as internal auditors. Moreover, objectivity is presumed to be impaired when 30 31 internal auditors audit any activity for which they had authority or responsibility. This impairment should be considered when reporting audit results. 5. Persons transferred to or temporarily engaged by the internal auditing department should not be assigned to audit those activities they previously performed until a reasonable period of time has elapsed. Such assignments are presumed to impair objectivity and should be considered when supervising the audit work and reporting audit results. 6. The results of internal auditing work should be reviewed before the related audit report is released to provide reasonable assurance that the work was performed objectively. 03 The internal auditor’s objectivity is not adversely affected when the auditor recommends standards of control for systems or reviews procedures before they are implemented. Designing, installing, and operating systems are not audit functions. Also, the drafting of procedures for systems is not an audit function. Performing such activities is presumed to impair audit objectivity. 200 PROFESSIONAL PROFICIENCY INTERNAL AUDITS SHOULD BE PERFORMED WITH PROFICIENCY AND DUE PROFESSIONAL CARE. 01. Professional proficiency is the responsibility of the director of internal auditing and each internal auditor. The director should ensure that persons assigned to each audit collectively possess the necessary knowledge, skills, and disciplines to conduct the audit properly. The Internal Auditing Department 210 Staffing The director of internal auditing should ensure that the technical proficiency and educational background of internal auditors are appropriate for the audits to be performed. 01. The director of internal auditing should establish suitable criteria of education and experience for filling internal auditing positions, giving due consideration to scope of work and level of responsibility. 02. Reasonable assurance should be obtained as to each prospective auditor’s qualifications and proficiency. 220 Knowledge, Skills, and Disciplines The internal auditing department should possess or should obtain the knowledge, skills, and disciplines needed to carry out its audit responsibilities. 01. The internal auditing staff should collectively possess the knowledge and skills essential to the practice of the profession within the organization. These attributes include proficiency in applying internal auditing standards, procedures, and techniques. 02. The internal auditing department should have employees or use outside service providers who are qualified in disciplines such as accounting, auditing, economics, finance, statistics, information technology, engineering, taxation, law, environmental affairs, and such other areas as needed to meet the department’s audit responsibilities. Each member of the department, however, need not be qualified in all disciplines. 1. An outside service provider is a person or firm, independent of the organization, who has special knowledge, skill, and experience in a particular discipline. Outside service providers include, among others, actuaries, accountants, appraisers, environmental specialists, fraud 31 32 investigators, lawyers, engineers, geologists, security specialists, statisticians, information technology specialists, the organization’s external auditors, and other auditing organizations. An outside service provider may be engaged by the board, senior management, or the director of internal auditing. 2. Outside service providers may be used by the internal auditing department in connection with, among other things: a. Auditing activities where a specialized skill and knowledge are required such as information technology, statistics, taxes, language translations, or to achieve the objectives in the audit work schedule. b. Valuations of assets such as land and buildings, works of art, precious gems, investments, and complex financial instruments. c. Determination of quantities or physical condition of certain assets such as mineral and petroleum reserves. d. Measuring the work completed and to be completed on contracts in progress. e. Fraud and security investigations. f. Determination of amounts by using specialized methods such as actuarial determinations of employee benefit obligations. g. Interpretation of legal, technical, and regulatory requirements. h. Evaluating the internal auditing department’s quality assurance program in accordance with Section 560 of the Standards. i. Mergers and acquisitions. 3. When the director of internal auditing intends to use and rely on the work of an outside service provider, the director should assess the competency, independence, and objectivity of the outside service provider as it relates to the particular assignment to be performed. This assessment should also be made when the outside service provider is selected by senior management or the board, and the director intends to use and rely on the outside service provider’s work. When the selection is made by others and the assessment determines that the director should not use and rely on the work of an outside service provider, then the results of the assessment should be communicated to senior management or the board, as appropriate. 4. The director of internal auditing should determine that the outside service provider possesses the necessary knowledge, skills, and ability to perform the assignment. When assessing competency, the director should consider the following: a. Professional certification, license, or other recognition of the outside service provider’s competency in their particular discipline. b. Membership of the outside service provider in an appropriate professional organization and adherence to that organization’s code of ethics. c. The reputation of the outside service provider. This may include contacting others familiar with the outside service provider’s work. d. The outside service provider’s experience in the type of work being considered. 32 9. The director of internal auditing should assess the relationship of the outside service provider to the organization and to the internal auditing department to ensure that independence and objectivity are maintained throughout the assignment. or personal relationships that will prevent the outside service provider from rendering impartial and unbiased judgments and opinions when performing or reporting on the assignment. If the outside service provider is also the organization’s external auditor and the nature of the assignment is extended audit services. or others within the organization. Additionally. senior management. The director of internal auditing should obtain sufficient information regarding the scope of the outside service provider’s work. b. This is necessary in order to ascertain that the scope of work is adequate for the purposes of the internal auditing department. Specific matters expected to be covered in the report to be rendered. Access to relevant records. In performing the assessment. if applicable. Objectives and scope of work. e. 33 . the director of internal auditing should consider: a. Compensation or other incentives that the provider may have. Independence. Information regarding assumptions and procedures to be employed. then their independence may be impaired. 8. management. external auditors may provide the organization with other services such as tax and consulting. however. The extent of other ongoing services the provider may be performing for the organization. and physical properties. e. d. f. personnel. In assessing the independence and objectivity of the outside service provider. if applicable. If the organization’s external auditors act or appear to act as members of senior management. c. 7. The relationship the provider may have had with the organization or the activities being reviewed. b. The extent of education and training received by the outside service provider in disciplines that pertain to the particular assignment. 5. 6. The personal or professional affiliation the provider may have to the board. or as employees of the organization. the director of internal auditing should determine that there are no financial. c. should be assessed in relation to the full range of services provided to the organization. organizational. Extended audit services refers to those services beyond the requirements of auditing standards generally accepted by external auditors. f. d. Ownership and custody of audit workpapers.33 e. The outside service provider’s knowledge and experience in the industry in which the organization operates. Confidentiality and restrictions on information obtained during the assignment. the director should ascertain that work performed does not impair the external auditor’s independence. The director of internal auditing should review with the outside service provider: a. The financial interest the provider may have in the organization. Supervision is a process which begins with planning and continues throughout the examination. Suitable means include policies and procedures designed to: 34 . 01. 10. The director is responsible for all significant professional judgments made in the planning. Ensuring that audit objectives are met. The director of internal auditing is responsible for ensuring that appropriate audit supervision is provided. prior to making such reference in the report. and timely. objective. and an outside service provider was used. and follow-up phases of the audit assignment. 11. The director should adopt suitable means to ensure that this responsibility is met. examination. the director may. 05. Determining that audit workpapers adequately support the audit findings. Providing opportunities for developing internal auditors’ knowledge and skills. Appropriately experienced internal auditors may be utilized to review the work of other internal auditors. report. When the director of internal auditing issues an audit report. In reviewing the work of an outside service provider. concurrence should be obtained. the director of internal auditing should specify and ensure that the work complies with the Standards for the Professional Practice of Internal Auditing. 12. 230 Supervision The director of internal auditing should ensure that internal audits are properly supervised. 4. whether performed by or for the internal auditing department. remain the responsibility of its director. The outside service provider should be informed or. refer to such services provided. This evaluation should include sufficiency of information obtained to afford a reasonable basis for the conclusions reached and the resolution of significant exceptions or other unusual matters. and reports. All internal auditing assignments. 03. and follow-up phases of the audit assignment. Ensuring that the auditors assigned possess the requisite knowledge and skills. clear. 7. Supervision includes: 1. 5. concise. evaluation. 3. report. if appropriate. constructive. as appropriate. Providing appropriate instructions during the planning of the audit and approving the audit program.34 It may be preferable to have these and other matters documented in an engagement letter or contract. 04. Appropriate evidence of supervision should be documented and retained. The extent of supervision required will depend on the proficiency and experience of internal auditors and the complexity of the audit assignment. conclusions. Where the outside service provider performs internal auditing activities. 2. evaluation. 6. 13. Ensuring that audit reports are accurate. the director of internal auditing should evaluate the adequacy of work performed. 02. Seeing that the approved audit program is carried out unless changes are both justified and authorized. 01. Supervision extends to staff training and development. 35 . or others performing work for the internal auditing department. 3. (b) further inquiry and/or research. and disciplines essential to the performance of internal audits. economics. taxation. 2. 06. Internal auditors should understand human relations and maintain satisfactory relationships with auditees. The Code calls for high standards of honesty. and loyalty to which internal auditors should conform. skills. An understanding means the ability to apply broad knowledge to situations likely to be encountered. Proficiency in accounting principles and techniques is required of auditors who work extensively with financial records and reports.35 1. and information technology. An understanding of management principles is required to recognize and evaluate the materiality and significance of deviations from good business practice. employee performance evaluation. 250 Knowledge. Each internal auditor should possess certain knowledge and skills as follows: 1. and techniques is required in performing internal audits. quantitative methods. finance. and (c) documentation and disposition of the differing viewpoints in the audit workpapers. and similar administrative areas. Proficiency means the ability to apply knowledge to situations likely to be encountered and to deal with them without extensive recourse to technical research and assistance. 240 Compliance with Standards of Conduct Internal auditors should comply with professional standards of conduct. 2 Resolve differences in professional judgment between the director and internal auditing staff members over significant issues relating to the audit assignment. The Code of Ethics of The Institute of Internal Auditors sets forth standards of conduct and provides a basis for enforcement. In instances of a difference in professional judgment over an ethical issue. Minimize the risk that professional judgments may be made by internal auditors. 01. An appreciation is required of the fundamentals of such subjects as accounting. Such means may include: (a) discussion of pertinent facts. that are inconsistent with the professional judgment of the director such that a significant adverse effect on the audit assignment could result. An appreciation means the ability to recognize the existence of problems or potential problems and to determine the further research to be undertaken or the assistance to be obtained. procedures. Proficiency in applying internal auditing standards. diligence. and to be able to carry out the research necessary to arrive at reasonable solutions. to recognize significant deviations. suitable means may include referral of the issue to those individuals in the organization having responsibility over ethical matters. 4. 01. 260 Human Relations and Communications Internal auditors should be skilled in dealing with people and in communicating effectively. objectivity. time and expense control. commercial law. Skills. and Disciplines Internal auditors should possess the knowledge. and participation in research projects. d.36 02. They should keep informed about improvements and current developments in internal auditing standards.g. Continuing education may be obtained through membership and participation in professional societies. regulations. f. valuation of goods exchanged between related organizations). management can improve the operating results of an organization involved in the transaction to the detriment of the other organization. b. 2. bribes. Prohibited business activities such as those which violate government statutes. inefficiency. Intentional failure to record or disclose significant information to improve the financial picture of the organization to outside parties. Internal auditors are responsible for continuing their education in order to maintain their proficiency. improper related-party transactions in which one party receives some benefit not obtainable in an arm’s-length transaction. They should also be alert to those conditions and activities where irregularities are most likely to occur. 280 Due Professional Care Internal auditors should exercise due professional care in performing internal audits. Internal auditors should be skilled in oral and written communications so that they can clearly and effectively convey such matters as audit objectives. c. By purposely structuring pricing techniques improperly. seminars. ineffectiveness. Due professional care calls for the application of the care and skill expected of a reasonably prudent and competent internal auditor in the same or similar circumstances. and techniques. 270 Continuing Education Internal auditors should maintain their technical competence through continuing education. In addition. conclusions. improper transfer pricing (e.. assets. or income. attendance at conferences. since personal benefit usually accrues when the organization is aided by the act. Improper payments such as illegal political contributions. Intentional. 01. internal auditors should be alert to the possibility of intentional wrongdoing. 36 . intermediaries of government officials. and payoffs to government officials. Intentional. Professional care should. It can be perpetrated for the benefit of or to the detriment of the organization and by persons outside as well as inside the organization. g. Fraud designed to benefit the organization generally produces such benefit by exploiting an unfair or dishonest advantage that also may deceive an outside party. rules. improper representation or valuation of transactions. Perpetrators of such frauds usually benefit indirectly. Intentional. kickbacks. evaluations. therefore. or suppliers. errors and omissions. and conflicts of interest. waste. In exercising due professional care. Fraud encompasses an array of irregularities and illegal acts characterized by intentional deception. e. or contracts. Some examples are: a. they should identify inadequate controls and recommend improvements to promote compliance with acceptable procedures and practices. customers. college courses. liabilities. Sale or assignment of fictitious or misrepresented assets. and in-house training programs. 1. procedures. be appropriate to the complexities of the audit being performed. 01. and recommendations. Recommendations need to be made for the establishment or enhancement of costeffective controls to help deter fraud. Diversion to an employee or outsider of a potentially profitable transaction that would normally generate profits for the organization. reports. Internal auditors are responsible for assisting in the deterrence of fraud by examining and evaluating the adequacy and the effectiveness of the system of internal control. Communication channels provide management with adequate and reliable information. commensurate with the extent of the potential exposure/risk in the various segments of the organization’s operations. thus making detection difficult. practices. b. code of conduct) exist that describe prohibited activities and the action required whenever violations are discovered. Nevertheless. not infallibility or extraordinary performance. d. and other sources both within and outside the organization. d. e. or another organization. but does not require detailed audits of all transactions. 1. as typified by the misappropriation of money or property. 4. Detection of fraud consists of identifying indicators of fraud sufficient to warrant recommending an investigation. procedures. and falsification of financial records to cover up the act. The organizational environment fosters control consciousness. 37 . the possibility of material irregularities or noncompliance should be considered whenever an internal auditor undertakes an internal auditing assignment.. g. internal auditors should. In carrying out this responsibility. Intentional concealment or misrepresentation of events or data. Written policies (e. The principal mechanism for deterring fraud is control.g. b. Due care requires the auditor to conduct examinations and verifications to a reasonable extent. c. Claims submitted for services or goods not actually provided to the organization. Tax fraud. c. 3. outside individual. These indicators may arise as a result of controls established by management. internal auditors cannot give absolute assurance that noncompliance or irregularities do not exist. Fraud perpetrated to the detriment of the organization generally is for the direct or indirect benefit of an employee. Acceptance of bribes or kickbacks. Primary responsibility for establishing and maintaining control rests with management. Policies. 02. for example. Embezzlement. Accordingly. Some examples are: a. and other mechanisms are developed to monitor activities and safeguard assets. f. e. Due care implies reasonable care and competence. determine whether: a. particularly in high-risk areas. Deterrence of fraud consists of those actions taken to discourage the perpetration of fraud and limit the exposure if fraud does occur. tests conducted by auditors. 5. Realistic organizational goals and objectives are set. Appropriate authorization policies for transactions are established and maintained.37 h. 3. c. the appropriate authorities within the organization should be informed. Be alert to opportunities. Thereafter. This can be critical to ensuring that the internal auditor avoids providing information to or obtaining misleading information from persons who may be involved. reputation. c. extent of the fraud. audit procedures alone. internal auditors should: a. b. unexplained pricing exceptions. 38 .38 2. override of controls. Notify the appropriate authorities within the organization if a determination is made that there are sufficient indicators of the commission of a fraud to recommend an investigation. Some examples of indicators are unauthorized transactions. and disciplines needed to effectively carry out the investigation. It includes gathering sufficient information about the specific details of a discovered fraud. Internal auditors. 03. Internal auditors should recognize that the presence of more than one indicator at any one time increases the probability that fraud may have occurred. Investigation of fraud consists of performing extended procedures necessary to determine whether fraud. security personnel. do not guarantee that fraud will be detected. licenses. and the types of frauds associated with the activities audited. Evaluate the indicators that fraud may have been committed and decide whether any further action is necessary or whether an investigation should be recommended. additional tests conducted by internal auditors should include tests directed toward identification of other indicators of fraud. If significant control weaknesses are detected. This should include assurances on such matters as professional certifications. An assessment of the qualifications and the skills of internal auditors and of the specialists available to participate in the investigation should be performed to ensure that it is conducted by individuals having the appropriate type and level of technical expertise. This knowledge includes the need to know the characteristics of fraud. techniques used. Design procedures to follow in attempting to identify the perpetrators. When an internal auditor suspects wrongdoing. and other specialists from inside or outside the organization are the parties that usually conduct or participate in fraud investigations. investigators. 1. the techniques used to commit fraud. Internal auditors are not expected to have knowledge equivalent to that of a person whose primary responsibility is detecting and investigating fraud. lawyers. has occurred. d. the internal auditor’s responsibilities for detecting fraud are to: a. In conducting audit assignments. Have sufficient knowledge of fraud to be able to identify indicators that fraud may have been committed. When conducting fraud investigations. even when carried out with due professional care. such as control weaknesses. that could allow fraud. as suggested by the indicators. and cause of the fraud. Also. the auditor should follow up to see that the internal auditing department’s responsibilities have been met. 2. and unusually large product losses. b. The internal auditor may recommend whatever investigation is considered necessary in the circumstances. skills. Determine the knowledge. and that there is no relationship to those being investigated or to any of the employees or management of the organization. Assess the probable level and the extent of complicity in the fraud within the organization. The adequacy and effectiveness of internal controls. conclusions. 2. Reporting of fraud consists of the various oral or written. In those cases in which the internal auditor wants to invoke client privilege. consideration should be given to addressing the report to legal counsel. 3. d. The cost of auditing in relation to potential benefits. legal counsel. 04 Exercising due professional care means using reasonable audit skill and judgment in performing the audit. internal auditors should assess the facts known in order to: a. Help meet the internal auditor’s responsibility to maintain sufficient knowledge of fraud and thereby be able to identify future indicators of fraud. interim or final communications to management regarding the status and results of fraud investigations. recommendations. and other specialists as appropriate throughout the course of the investigation. Section 430 of the Standards provides interpretations applicable to internal audit reports issued as a result of fraud investigations. A written report should be issued at the conclusion of the investigation phase. b. Design audit tests to help disclose the existence of similar frauds in the future. The relative materiality or significance of matters to which audit procedures are applied. Coordinate activities with management personnel. senior management and the board should be notified immediately. c. 4. A draft of the proposed report on fraud should be submitted to legal counsel for review. 3. Once a fraud investigation is concluded. b. the internal auditor should consider: 1. It should also summarize findings that serve as the basis for such decision. The report should include the internal auditor’s conclusion as to whether sufficient information exists to conduct an investigation. To this end. When the incidence of significant fraud has been established to a reasonable certainty. It should include all findings.39 d. Internal auditors should inform senior management and the board of such a discovery. e. 39 . The extent of audit work needed to achieve audit objectives. 4. Additional interpretive guidelines on reporting of fraud are as follows: a. c. Determine if controls need to be implemented or strengthened to reduce future vulnerability. The results of a fraud investigation may indicate that fraud has had a previously undiscovered significant adverse effect on the financial position and results of operations of an organization for one or more years on which financial statements have already been issued. 5. A preliminary or final report may be desirable at the conclusion of the detection phase. 6. and corrective action taken. Be cognizant of the rights of alleged perpetrators and personnel within the scope of the investigation and the reputation of the organization itself. of Volume 1. COMMUNICATING RESULTS. The form and content of written policies and procedures should be appropriate to the size and structure of the internal auditing department and the complexity of its work. 01. 01. 300 SCOPE OF WORK THE SCOPE OF INTERNAL AUDITING SHOULD ENCOMPASS THE EXAMINATION AND EVALUATION OF THE ADEQUACY AND EFFECTIVENESS OF THE ORGANIZATION’S SYSTEM OF INTERNAL CONTROL AND THE QUALITY OF PERFORMANCE IN CARRYING OUT ASSIGNED RESPONSIBILITIES. Note: The full text of this section is printed in Unit 3 of Volume 1. AND FOLLOWING UP. 2. Note: The full text of this section is printed in Unit 4 of Volume 1. 500 MANAGEMENT OF THE INTERNAL AUDITING DEPARTMENT THE DIRECTOR OF INTERNAL AUDITING SHOULD PROPERLY MANAGE THE INTERNAL AUDITING DEPARTMENT. more formal and 40 . 400 PERFORMANCE OF AUDIT WORK AUDIT WORK SHOULD INCLUDE PLANNING THE AUDIT. If internal auditors are required to interpret or select operating standards. Its audit staff may be directed and controlled through daily. Resources of the internal auditing department are efficiently and effectively employed. 3. 530 Policies and Procedures The director of internal auditing should provide written policies and procedures to guide the audit staff. Formal administrative and technical audit manuals may not be needed by all internal auditing departments. Note: The full text of Sections 510 and 520 are printed in Units 2 and 4respectively.40 05 Due professional care includes evaluating established operating standards and determining whether those standards are acceptable and are being met. Audit work conforms to the Standards for the Professional Practice of Internal Auditing. authoritative interpretations should be sought. When such standards are vague. A small internal auditing department may be managed informally. Audit work fulfills the general purposes and responsibilities approved by senior management and accepted by the board. they should seek agreement with auditees as to the standards needed to measure operating performance. EXAMINING AND EVALUATING INFORMATION. In a large internal auditing department. close supervision and written memoranda. The director of internal auditing is responsible for properly managing the department so that: 1. the external auditors’ ordinary examination is designed to obtain sufficient evidential matter to support an opinion on the overall fairness of the annual financial statements. 5. Developing written job descriptions for each level of the audit staff. 01. 01. On the other hand. Such evaluations may also include assessments of the overall efficiency and effectiveness of internal and external auditing activities. 550 External Auditors The director of internal auditing should coordinate internal and external audit efforts. Appraising each internal auditor’s performance at least annually. The director of internal auditing will require the support of the board to achieve effective coordination of audit work. The scope of internal auditing work encompasses both financial and operational objectives and activities. Selecting qualified and competent individuals. The director of internal auditing may agree to perform work for external auditors in connection with their annual audit of the financial statements.41 comprehensive policies and procedures are essential to guide the audit staff in the consistent compliance with the department’s standards of performance. including coordination with the internal auditing department. including aggregate audit cost. 41 . 5. 2. 4. Training and providing continuing educational opportunities for each internal auditor. 3. 1. The director of internal auditing should make regular evaluations of the coordination between internal and external auditors. In coordinating the work of internal auditors with the work of external auditors. The program should provide for: 1. is generally the responsibility of the board. Oversight of the work of external auditors. Actual coordination should be the responsibility of the director of internal auditing. To the extent that professional and organizational reporting responsibilities allow. 2. 3. The scope of internal auditing work is covered by Section 300 of the Standards. and they are responsible for judging the adequacy of procedures performed and evidence obtained for purposes of expressing their opinion on the annual financial statements. Work performed by internal auditors to assist external auditors in fulfilling their responsibility is subject to all relevant provisions of the Standards for the Professional Practice of Internal Auditing. the director of internal auditing should ensure that work to be performed by internal auditors in fulfillment of Section 300 of the Standards does not duplicate the work of external auditors which can be relied on for purposes of internal auditing coverage. 540 Personnel Management and Development The director of internal auditing should establish a program for selecting and developing the human resources of the internal auditing department. internal auditors should conduct examinations in a manner that allows for maximum audit coordination and efficiency. Providing counsel to internal auditors on their performance and professional development. The scope of the work of external auditors is determined by their professional standards. 4. Internal and external auditing work should be coordinated to ensure adequate audit coverage and to minimize duplicate efforts. g. any relevant comments about the performance of external auditors. i. Difficulties encountered in performing the audit. Assessments of the performance of external auditors extending to matters beyond coordination with the internal auditors may address such additional factors as: a. The director of internal auditing should communicate the results of evaluations of coordination between internal and external auditors to senior management and the board along with. h. f. b. Significant control weaknesses. Professional knowledge and experience. c. the board may request the director of internal auditing to assess the performance of external auditors. Knowledge of the organization’s industry. e. Significant audit adjustments. Management judgments and accounting estimates. Illegal acts. Such assessments should ordinarily be made in the context of the director of internal auditing’s role of coordinating internal and external auditing activities. These matters may include: a. 10. g. e. Assessments of the performance of external auditors should be based on sufficient information to support the conclusions reached. 7. 8. Anticipation of and responsiveness to the needs of the organization. Availability of specialized services.02 of the Standards. Achievement of contract commitments. The director of internal auditing should communicate with external auditors regarding these matters so as to have an understanding of the issues. Delivery of overall value to the organization. External auditors may be required by their professional standards to ensure that certain matters are communicated to the board. 42 . In exercising its oversight role. Assessments of the external auditors’ performance with respect to the coordination of internal and external auditing activities should reflect the criteria described in Section 550. f. Disagreements with management. and should extend to other performance matters only at the specific request of senior management or the board. 9. c. Independence. as appropriate.42 6. d. d. Maintenance of appropriate working relationships. Errors and irregularities. Reasonable continuity of key engagement personnel. b. Similarly. Coordination of audit efforts involves: 1. and terminology to facilitate reliance by external auditors on work performed using such techniques. a. and (c) ensure that internal auditors who are to perform work to fulfill the external auditors’ objectives can communicate effectively with external auditors. c. methods. of relying on the internal auditors’ work. management’s responses to those reports. and terminology. 4. and subsequent internal auditing department follow-up reviews should be made available to external auditors. Matters discussed in management letters assist internal auditors in planning the areas to emphasize in future internal audit work. 43 . Planned audit activities of internal and external auditors should be discussed to assure that audit coverage is coordinated and duplicate efforts are minimized. methods. Access to each other’s audit programs and workpapers. (b) evaluate. satisfies the requirements of Section 300 of the Standards. The director of internal auditing should ensure that the external auditors’ techniques. Such satisfaction requires an understanding of the level of materiality used by external auditors for planning and the nature and extent of the external auditors’ planned procedures. Internal audit reports. Access to the external auditors’ programs and workpapers may be important in order for internal auditors to be satisfied as to the propriety for internal audit purposes of relying on the external auditors’ work. and terminology are sufficiently understood by internal auditors to enable the director of internal auditing to (a) coordinate internal and external auditing work. for purposes of reliance. Sufficient meetings should be scheduled during the audit process to assure coordination of audit work and efficient and timely completion of audit activities. Internal auditors need access to the external auditors’ management letters. 2. methods. The director of internal auditing should provide sufficient information to enable external auditors to understand the internal auditors’ techniques. Periodic meetings to discuss matters of mutual interest. the director of internal auditing should ensure that appropriate follow-up and corrective action have been taken. b. a. Exchange of audit reports and management letters. for external audit purposes. methods. in conjunction with the internal auditors’ planned work. a. Common understanding of audit techniques. After review of management letters and initiation of any needed corrective action by appropriate members of management and the board. and to determine whether findings from work performed to date require that the scope of planned work be adjusted. Such access carries with it the responsibility for internal auditors to respect the confidentiality of those programs and workpapers. 3. The director of internal auditing should understand the scope of work planned by external auditors and should be satisfied that the external auditors’ planned work. a. b. the external auditors’ work. These reports assist external auditors in determining and adjusting the scope of work.43 02. access to the internal auditors’ programs and workpapers should be given to external auditors in order for external auditors to be satisfied as to the propriety. and terminology. 44 a. The following are examples of other applicable standards and potential measurement criteria that should be considered in evaluating the performance of the internal auditing department: a. — External reviews. 01. methods. g. statements of job requirements. 3. The plan of organization. e. each of whom may have reasons to rely upon the performance of the internal auditing department. regulations. The purpose of this program is to provide reasonable assurance that internal auditing work conforms with the Standards for the Professional Practice of Internal Auditing. and determining frequency and scope of audits. c. 2. f. — Internal reviews. It includes performance of the internal auditing department at a high level of efficiency and effectiveness. Methods for identifying auditable activities. 4. and government or industry standards which specify auditing and reporting requirements. and professional development plans of the internal auditing department. b. as well as to maintaining the internal auditing department’s credibility with those it serves. Laws. Conformity with applicable standards is more than simply complying with established policies and procedures. d. Quality assurance is essential to achieving such performance. Audit planning documents. particularly those submitted to senior management and the board. A quality assurance program should include the following elements: — Supervision. and terminology to effectively coordinate their work and to rely on the work of one another. position descriptions. the board. and procedures. The reasonable assurance mentioned in this guideline serves the needs of several constituencies in addition to that of the director of internal auditing. policies. assessing risk. external auditors. The internal auditing department’s objectives. These may include senior management. 44 . and other applicable standards. The Code of Ethics. 560 Quality Assurance The director of internal auditing should establish and maintain a quality assurance program to evaluate the operations of the internal auditing department. It may be more efficient for internal and external auditors to use similar techniques. 1. Consideration of the department’s charter should also include an assessment of the charter in terms of the elements specified in Section 110 of the Standards. The organization’s policies and procedures that apply to the internal auditing department. and regulatory agencies. A key criterion against which an internal auditing department should be measured is its charter. the internal auditing department’s charter. or to supplement such reviews. These reviews should be structured so as to indicate the degree of compliance with the Standards for the Professional Practice of Internal Auditing. The director of internal auditing should initiate and monitor the internal review process. 3. the following methods can provide elements of internal review coverage: a. audit managers. and greater uniformity. the board. Reviews by the director of internal auditing. the director of internal auditing should ensure that the team is qualified and as independent as practicable. 1. level of audit effectiveness. 45 . either routinely after each audit or periodically for selected audits. These reviews should be performed in the same manner as any other internal audit. Although the purpose of internal reviews is to assess the effectiveness of the internal auditing department for internal purposes. The director should receive a written report of the results of each internal review and ensure that appropriate action is taken. or supervisors of a sample of audits (and areas of audit administration) where the work was performed under the direction of other managers or supervisors. The nature and responsibility for supervision are set forth in Section 230 of the Standards. As an ongoing process this can provide training. These reviews generally are performed by a team or an individual selected by the director of internal auditing. Internal quality assurance reviews primarily serve the needs of the director of internal auditing. Larger departments may have a person designated as manager of quality assurance or with a similar title and responsibilities. departmental policies. as well as assurance to the director of internal auditing. it provides a foundation upon which internal and external reviews can subsequently be built. 03. In selecting and instructing the team for an internal review. Internal reviews can also be useful as part of the self-assessment process in preparation for an external review. 1. Formal internal reviews are periodic self-assessments of the internal auditing department. 6. but can also provide senior management and the board with an assessment of the internal auditing department. As such. it may be appropriate for the director to share the results with persons outside the department. Supervision of the work of internal auditors should be carried out to assure conformance with internal auditing standards. and audit programs. 2. An internal review program. This process will elicit management’s perception of the internal auditing department and may also result in suggestions to make it more effective and responsive to management’s needs. and external auditors. exchange of ideas. 5. 2. Adequate supervision is the most fundamental element of a quality assurance program. Feedback from auditees (in addition to that from personal contact) through the use of questionnaires or surveys. such as senior management. particularly in smaller internal auditing departments. b. and related guidelines. will require adaptations that take into consideration the structure of the department and degree of involvement of the director in individual audits. and extent of compliance with the organization and departmental policies and standards. The review should also provide recommendations for improvement. 4. When formal internal reviews are not appropriate to the internal auditing department’s needs.45 02. Internal reviews should be performed periodically by members of the internal auditing staff to appraise the quality of the audit work performed. It is the responsibility of the director of internal auditing to annually assess the conditions which restrict an external review. The director of internal auditing should prepare a written action plan in response to the significant comments and recommendations contained in the report of external review. Organizations of external auditors in various countries have specified certain limited review procedures that they should consider in evaluating and using the work of the internal auditing department. These relate primarily to quality of work and degree of independence from auditees. a formal. However. and other quality assurance methods that are available to the department. the internal auditing department may be currently unable to obtain an external review. the board. other audit directors in a decentralized audit organization. and overall results of the internal review program should also be considered in determining the external review interval. The report should express an opinion as to the department’s compliance with the Standards for the Professional Practice of Internal Auditing and. as appropriate. and (c) the relative stability of the internal auditing department’s charter. periodic internal reviews.g. Appropriate follow-up is also the director’s responsibility. 4. or 46 . more emphasis should be placed on supervision. External reviews can have considerable value to the director and other members of the internal auditing department. 6. degree of independence. Such reviews should be conducted at least once every three years. The report should also address compliance with the department’s charter and other applicable standards and include appropriate recommendations for improvement. The nature.. External reviews of the internal auditing department should be performed to appraise the quality of the department’s operations. should include recommendations for improvement. written report should be issued. the review team should issue a formal report containing an opinion as to the department’s compliance with the Standards. Another important purpose of external reviews is to provide independent assurance of quality to senior management. Independent of the organization means not a part of. The report should be addressed to the person or organization who requested the review. and catalog of auditable activities. staff. the organization to which the internal auditing department belongs. In these circumstances. In the selection of an external reviewer. External reviews should be conducted at least once every three years. 3. These reviews should be performed by qualified persons who are independent of the organization and who do not have either a real or an apparent conflict of interest. These limited review procedures by external auditors usually relate only to their audit of an organization’s financial statements and generally would not constitute an external review. 2. 5. External reviews should be performed by qualified individuals who are independent of the organization and who do not have either a real or an apparent conflict of interest. consideration should be given to a possible real or apparent conflict of interest which the reviewer may have due to present or past relationships with the organization or its internal auditing department. or under the control of. On completion of the review. if resources are limited. scope. there may be circumstances that justify a different interval. and others such as external auditors who rely on the work of the internal auditing department.46 04. These circumstances include: (a) significant review and monitoring by the board. However. Another interim method is the use of qualified internal groups to conduct a review (e. former audit managers in the employ of the organization. 1. organization. (b) in-depth reviews by external auditors or others. or for other reasons previously noted. 7. Qualified individuals are persons with the technical proficiency and educational background appropriate for the audit activities to be reviewed and could include internal auditors from outside the organization or outside service providers. The director of internal auditing should discuss with senior management and the board the nature of an external review in the context of the overall quality assurance program and should involve them in the selection of an external reviewer. External review is an important element of the program for achieving quality assurance. Upon completion of an external review. These two statements are summarized below. b. 3. Considering knowledge from prior-year audits. and extent of the audit work. including the nature. d. 1. 47 . Organizational status within the entity. Application of professional standards. When obtaining an understanding of internal control. Summary of SAS 65 “The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements. SAS 65 provides the auditor with guidance on considering the work of internal auditors and on using internal auditors to provide assistance to the auditor in an audit performed in accordance with generally accepted auditing standards. Two AICPA standards relate to the independent auditor’s consideration of work by outside entities. AICPA STATEMENTS ON AUDITING STANDARDS (SAS) Independent auditors occasionally receive assistance or information from outside sources when conducting an audit. The auditor may find the results of the following procedures helpful in assessing the relevancy of internal audit activities: 1.47 internal management advisory personnel). timing. and SAS 70. which describes the consideration of reports on the processing of transactions by service organizations. 4. the auditor should obtain an understanding of the internal audit function sufficient to identify those internal audit activities that are relevant to planning the audit. 3. The auditor ordinarily should make inquiries of appropriate management and internal audit personnel about the internal auditors’: 1. such a review should not be expected to achieve all of the objectives of an external review. 2. Reading internal audit reports to obtain detailed information about the scope of internal audit activities. c. 2. Reviewing how the internal auditors allocate their audit resources to financial or operating areas in response to their risk assessment process.” a. Access to records and whether there are limitations on the scope of their activities. However. Audit plan. D. SAS 65 describes the auditor’s consideration of the internal audit function in an audit of financial statements. or the ownermanager oversees employment decisions related to the internal auditor. Even though the internal auditors’ work may affect the auditor’s procedures. Audit policies. programs. 2.48 e. g. the auditor should perform procedures to obtain sufficient and competent evidential matter to support the auditor’s report. including: • Whether the internal auditor reports to an officer of sufficient status to ensure broad coverage and adequate consideration of. Whether the board of directors. Supervision and review of internal auditors’ activities. reports. and recommendations. Policies prohibiting internal auditors from auditing areas where they were recently assigned or are scheduled to be assigned on completion of responsibilities in the internal audit function. • • 2. f. Professional certification and continuing education. the auditor should obtain or update information from prior years about such factors as: 1. When assessing the internal auditors’ objectivity. Educational level and professional experience of internal auditors. 6. and procedures. Whether the internal auditor has direct access and reports regularly to the board of directors. Evaluation of internal auditors’ performance. including: • • Policies prohibiting internal auditors’ from auditing areas where relatives are employed in important or audit-sensitive areas. Policies to maintain internal auditors’ objectivity about the areas audited. When assessing the internal auditors’ competence. 48 . The organizational status of the internal auditor responsible for the internal audit function. and action on. the auditor should obtain or update information from prior years about such factors as: 1. 7. Practices regarding assignment of internal auditors. Quality of workpaper documentation. 4. or the owner-manager. the audit committee. 3. 5. the findings and recommendations of the internal auditors. the audit committee. it may be efficient for the auditor and the internal auditors to coordinate their work by: 1. at least in part. Examples of service organizations include bank trust departments that invest and hold assets for employee benefit plans or for others. mortgage bankers that service mortgages for others. Scheduling audit work. 3. 2. Workpapers adequately document work performed. or recording transactions and processing related data. and electronic data processing service centers that process transactions and related data for others. Holding periodic meetings. i. Audit programs are adequate. This section provides guidance on the factors an independent auditor should consider when auditing the financial statement of an entity that uses a service organization to process certain transactions. If the work of the internal auditors is expected to have an effect on the auditor’s procedures. 49 .49 h. Reviewing audit reports. Service organizations typically provide services such as executing transactions and maintaining the related accountability. b. When a user organization uses a service organization. The auditor should perform procedures to evaluate the quality and effectiveness of the internal auditors’ work. Providing access to internal auditors’ workpapers.” a. 2. 4. 4. c. transactions that affect the user organization’s financial statements are subjected to controls that are. Conclusions are appropriate in the circumstances. Reports are consistent with the results of the work performed. 3. 5. Scope of work is appropriate to meet the objectives. Discussing possible accounting and auditing issues. 5. Summary of SAS 70 “Reports on the Processing of Transactions by Service Organizations. the auditor should consider such factors as whether the internal auditors’: 1. 2. In developing the evaluation procedures. including evidence of supervision and review. certain controls and records of the service organization may be relevant to the user organization’s ability to record. including those that are affected by the activities of the service organization. 6. The inherent risk associated with the assertions affected by the controls of the service organization. The user auditor’s prior experience with the service organization. After obtaining an understanding of internal controls. including its record of performance. 5. 2. The relationship of the controls of the service organization to those of the user organization depends primarily on the nature of the services provided by the service organization.50 physically and operationally separate from the user organization. 7. insurance coverage. and report financial data consistent with the assertions embodied in the entity’s financial statements. The terms of the contract between the user organization and the service organization (for example. their respective responsibilities and the extent of the service organization’s discretion to initiate transactions). 4. e. The extent of auditable data in the user organization’s possession. and financial stability. 50 . the user should consider such factors as: 1. summarize. If an entity uses a service organization. process. 9. 3. The existence of specific regulatory requirements that may dictate the application of audit procedures beyond those required to comply with generally accepted auditing standards. 10. the user auditor assesses control risk for the assertions embodied in the account balances and classes of transactions. 8. The significance of the financial statement assertions that are affected by the controls of the service organization. In determining the significance of these controls and records to planning the audit. The nature of the services provided by the service organization and whether they are highly standardized and used extensively by many user organizations or unique and used only by a few. The user organization’s controls that are applied to the transactions affected by the service organization’s activities. d. The service organizations capabilities. The extent to which the user organization’s controls interact with the controls of the service organization. Thus. Article One A Certified Financial Services Auditor shall at all times demonstrate a commitment to professionalism in the performance of his or her duties. Article Two A Certified Financial Services Auditor shall at all times exhibit the highest levels of honesty. the CFSA like most professional organizations has defined a code of professional ethics. Article Four A Certified Financial Services Auditor will neither use information obtained during an audit for personal gain nor allow anyone else to use such information for personal gain. E. integrity and objectivity in the performance of his or her duties and responsibilities. The service auditor’s report is used in the audit. in part. The user auditor’s assessments of control risk regarding assertions about account balances or classes of transactions are based on the combined evidence provided by the service auditor’s report and the user auditor’s own procedures.51 f. 51 . CFSA Code of Professional Ethics To promote professionalism and integrity among its member. there cannot be a division of responsibility for the audit of the financial statements. but the service auditor is not responsible for examining any portion of the financial statements as of any specific date or for any specified period. The user organization may establish effective controls over the service organization’s activities that may be tested and that may enable the user auditor to reduce the assessed level of control risk below the maximum for some or all of the related assertions. Article Five A Certified Financial Services Auditor will use the designation of CFSA with pride and professionalism and will continue to strive to enhance his or her proficiency and value to the profession. The user auditor should not make reference to the report of the service auditor as a basis. for his or her own opinion on the user organization’s financial statements. Article Three A Certified Financial Services Auditor shall not knowingly engage in any illegal or fraudulent act. g. h. 52 Article Six A Certified Financial Services Auditor shall not engage in any activity deemed to be in conflict with the interests of the Association or which would compromise personal objectivity. 52 . and efficient use of resources. Audit Charter B. Internal control is a management process designed to provide reasonable assurance regarding the achievement of the following objectives: • • • • • Assessing the reliability and integrity of information. plans. At the inception of internal auditing. Audit charters typically provide detailed information on the objectives of the internal audit department. Reporting Responsibility C. The charter establishes the general authority and responsibility of the internal audit department to conduct audits. authority. 53 . Assessing economical. Assessing compliance with policy. compliance auditing became an internal audit responsibility. An audit charter is generally an official policy statement that establishes an internal audit function as an independent appraisal activity to examine and evaluate the operations of the organization. the focus was on the safeguarding of assets and fraud detection. Audit Charter IIA Standard 510 Purpose. and responsibility for the internal auditing department. There are three key components of effective internal audit organizations. Assessing the accomplishment of established objectives and goals for an operation or program. As policies. An audit charter may contain a statement such as: The primary objective of an internal audit function is to assist management achieve its objectives through advice on risk management and internal control practices. and Responsibility The director of internal auditing should have a statement of purpose. effective. regulations. Appraising the safeguarding of assets. procedures. The director of internal auditing is responsible for seeking the approval of senior management and the acceptance by the board of a formal written document (charter) for the internal auditing department. Audit Committee A.53 UNIT 2: INTERNAL AUDIT ORGANIZATION As management encountered increasing difficulty in monitoring operations and activities. laws and regulations. 1. internal audit departments became a necessary function. 2. Authority. They are: A. and laws increased. 01. property. To remain independent. Internal audit must have the ability to bypass executive management and bring issues directly to the audit committee and/or board of directors if warranted. integrity. and in no way relieve line department personnel of operating responsibilities assigned to them. It helps an organization accomplish its objectives by bringing a systematic. In addition. design. Helping to generate an awareness of risk management and effective control techniques with a commitment to using them throughout the organization. control. and personnel. The plan is usually based on a risk assessment and will be the guide for audit activity throughout the year. Charters often provide for the internal audit department to have unrestricted access to all organization activities. Reporting Responsibility 1. disciplined approach to evaluate and improve the effectiveness of risk management. 3. reliability. objective assurance and consulting activity designed to add value and improve an organization's operations. New Definition of Internal Auditing Internal auditing is an independent. it must be made clear that internal auditors perform advisory functions only. Introduction to IIA Standards. The charter may require the development of an annual audit plan. As indicated in the Unit 1. The charter usually establishes the independence of the internal audit department and the reporting requirements. section. and monitor internal control systems to ensure that objectives are achieved. and usefulness of management information systems. a new Definition of Internal Auditing was approved by The IIA's Board of Directors in June 1999. 54 . Internal audit will help define. 2. nor direct responsibility for.54 • • • Appraising the adequacy. Internal audit scope includes all activities of the organization and its controlled entities. security. records. Cooperating in providing a range of professional internal consulting services to management. any of the activities they review. internal audit departments should not have authority over. B. Management is responsible for determining acceptable levels of risk and to ensure adequate internal control systems are in place. B. and governance processes 3. The internal auditor usually reports to an audit committee (see following section) and/or an executive level manager. The internal audit plan is prepared in consultation with management and the Audit Committee and approved by the Committee each year. Some examples of audit committee's duties are: • • • • • • • • • Oversee the company's internal control structure over financial reporting Review the work of the internal audit department Recommend the independent auditors Review the plan for the annual audit with the independent auditors Review the results of the audit with the independent auditors Review the annual report Review the process of assessing the risk of fraudulent financial reporting Monitor procedures for compliance with government regulations Communicate with corporate counsel and assess the effect of litigation on the financial statements 3. the independent auditors. To achieve this objective. external entities are continually placing greater demands on the audit committee. 4. 5. the public markets. In February 1999. The audit committee may assist the board of directors in fulfilling its oversight responsibility over the financial reporting process and the internal control structure and maintain communication on these matters among the board of directors. and must be independent of the company's management in substance as well as appearance. Although the audit committee's duties and responsibilities generally reflect the company's specific needs and characteristics. rather than in-depth knowledge in one area. An increasing number of companies have been forming audit committees because of the requirements of regulatory bodies and because boards of directors are recognizing that audit committees play a key role in corporate accountability and governance. 55 . the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (Blue Ribbon Committee) issued its Report and Recommendations with respect to audit committee composition and practices. Audit committees are involved in a broad range of corporate concerns. high-quality. and internal auditors. The central message of the Blue Ribbon Committee’s report and the intent of the new rules is that audit committees need to be diligent in their oversight of the financial reporting process. and timely disclosure of financial and other information to the board. Audit committee members should have broad knowledge and experience in financial matters. the Securities and Exchange Commission.55 C. 2. and shareholders. some of which are extensions of the committee's traditional role. Also. audit committees need to work closely with management. internal auditors. and independent auditors to promote accurate. the securities exchanges and the Auditing Standards Board adopted rules in response to the Blue Ribbon Committee’s recommendations. An audit committee's primary purpose is to protect the interests of the shareholders and directors. Audit Committee iv 1. management. in a collaborative effort. or executive officer of an organization that has a business relationship with the company. the following restrictions shall apply to every audit committee member: (a) Employees.. or must become financially literate within a reasonable period of time after his or her appointment to the audit committee. the Board of Directors should consider.56 The rule changes from the NYSE and NASD (the latter of which apply to both NASDAQ and Amex listed companies) amend their audit committee requirements in order to strengthen the independence and qualifications of the audit committee. all of whom have no relationship to the company that may interfere with the exercise of their independence from management and the company ("Independent"). Independence Requirement of Audit Committee Members. These disclosure requirements are further discussed in the section titled “Disclosure by Audit Committees”. In the event the employment relationship is with a former parent or predecessor of the company. A director who is an employee (including non-employee executive officers) of the company or any of its affiliates may not serve on the audit committee until three years following the termination of his or her employment. companies should keep in mind that the new securities exchange rules also require written affirmation (NYSE) or certification (NASD) regarding the independence and qualifications of audit committee members. (b) Each member of the audit committee shall be financially literate. a consultant) may serve on the audit committee only if the company's Board of Directors determines in its business judgment that the relationship does not interfere with the director's exercise of independent judgment. A director (i) who is a partner. In addition to the definition of Independent provided above. In making a determination regarding the independence of a director pursuant to this paragraph. Companies need to assess whether their audit committees comply with the new composition and qualifications requirements. controlling shareholder. Following are the new NYSE rules regarding the attributes of the audit committee: Composition/Expertise Requirement of Audit Committee Members. Further.g. as such qualification is interpreted by the company's Board of Directors in its business judgment. or (ii) who has a direct business relationship with the company (e. In making their assessment. as the Board of Directors interprets such qualification in its business judgment. (a) Each audit committee shall consist of at least three directors. new SEC rules require annual proxy statement disclosures regarding audit committee member independence. (b) Business Relationship. and (c) At least one member of the audit committee must have accounting or related financial management expertise. among other 56 . the director could serve on the audit committee after three years following the termination of the relationship between the company and the former parent or predecessor. parent company. and the company discloses. brothers and sisters-in-law. to the audit committee if the company's board of directors determines in its business judgment that membership on the committee by the individual is required by the best interests of the corporation and its shareholders. siblings. to the organization with which the director is affiliated. (2) the relationship between the director and his or her partnership status. A director who is an Immediate Family member of an individual who is an executive officer of the company or any of its affiliates cannot serve on the audit committee until three years following the termination of such employment relationship. (d) Immediate Family. legal. the nature of the relationship and the reasons for that determination. the materiality of the relationship to the company. banking. "Immediate Family" includes a person's spouse. parents. The director may serve on the audit committee without the abovereferenced Board of Directors' determination after three years following the termination of. 3 (c) Cross Compensation Committee Link. and anyone (other than employees) who shares such person's home. but is not considered independent pursuant to these provisions due to the three-year restriction period. "Affiliate" includes a subsidiary. in the next annual proxy statement subsequent to such determination. to the director. "Officer" shall have the meaning specified in Rule 16a-1(f) under the Securities Exchange Act of 1934. One director who is no longer an employee or who is an Immediate Family member of a former executive officer of the company or its affiliates. and. either (1) the relationship between the organization with which the director is affiliated and the company. A director can have this relationship directly with the company. may be appointed. shareholder interest or executive officer position. mothers-inlaw and fathers-in-law. "Business relationships" can include commercial. or the director can be a partner. “The term ‘officer’ 57 . children. or any successor rule. consulting. industrial. under exceptional and limited circumstances. or former parent company. Independence Exception. as applicable. accounting and other relationships. sons and daughters-in-law. A director who is employed as an executive of another corporation where any of the company's executives serves on that corporation's compensation committee may not serve on the audit committee. predecessor. Companies listing in conjunction with their initial public offering (including spin-offs and carve outs) will be required to have two qualified audit committee members in place within three months of listing and a third qualified member in place within twelve months of listing. if applicable.57 things. sibling company. officer or employee of an organization that has such a relationship. Rule 16a-1(f) states. or (3) the direct business relationship between the director and the company. Initial Public Offering. and certify that it has and will continue to have. Additionally. or any other person who performs similar policy-making functions for the issuer. or has been in any of the past three years. principal financial officer. father-in-law.” Following are the new NASD rules regarding the attributes of the audit committee: Audit Committee Composition. an audit committee of at least three members. Each issuer must have. or non-discretionary compensation. benefits under a tax-qualified retirement plan. parents. and anyone who resides in such person's home. other than compensation for board service. 58 . Officers of the issuer's parent(s) or subsidiaries shall be deemed officers of the issuer if they perform such policy-making functions for the issuer. When the issuer is a trust. (b) a director who accepts any compensation from the corporation or any of its affiliates in excess of $60. sister-in-law. mother-in-law. would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. (c) a director who is a member of the immediate family of an individual who is. administration or finance). when the issuer is a limited partnership. if there is no such accounting officer. children. In addition. division or function (such as sales. the controller). siblings. chief financial officer or other senior officer with financial oversight responsibilities. and will continue to have. each issuer must certify that it has. and cash flow statement or will become able to do so within a reasonable period of time after his or her appointment to the audit committee. officers or employees of the trustee(s) who perform policy-making functions for the trust are deemed officers of the trust. employed by the corporation or any of its affiliates as an executive officer. principal accounting officer (or. officers or employees of the general partner(s) who perform policy-making functions for the limited partnership are deemed officers of the limited partnership. including being or having been a chief executive officer. son-in-law. in the opinion of the company's board of directors. income statement. brother-in-law. comprised solely of independent directors. The following persons shall not be considered independent: (a) a director who is employed by the corporation or any of its affiliates for the current year or any of the past three years. Immediate family includes a person's spouse. daughterin-law. any other officer who performs a policy-making function.000 during the previous fiscal year. requisite professional certification in accounting. “Independent director” means a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship which.58 shall mean an issuer's president. at least one member of the audit committee that has past employment experience in finance or accounting. including a company's balance sheet. any vice-president of the issuer in charge of a principal business unit. or any other comparable experience or background which results in the individual's financial sophistication. each of whom is able to read and understand fundamental financial statements. or a controlling shareholder or an executive officer of.htm Background information and the text of the Securities and Exchange Commission’s final audit committee-related rules may be found at the following Worldwide Web address: http://www. Audit Committee Communications. 59 . any for-profit business organization to which the corporation made. For more information on these new rules go to: Background information and the text of the New York Stock Exchange and National Association of Securities Dealers final audit committee-related rules may be found at the following Worldwide Web address: http://www.sec. Such issuers must establish and maintain an audit committee of at least two members. in the next annual proxy statement subsequent to such determination. Exception for Small Business Filers – The new composition (three members) and qualification (financially literate) requirements do not apply to issuers that file reports under SEC Regulation S-B. the nature of the relationship and the reasons for that determination. and is not a current employee or an immediate family member of such employee. whichever is more. in any of the past three years.sec.59 (d) a director who is a partner in. which amends Statement on Auditing Standards No. 61. 71. Communication with Audit Committees.gov/rules/finrindx. Audit Committees.gov/rules/sroindx. payments (other than those arising solely from investments in the corporation's securities) that exceed 5% of the corporation's or business organization's consolidated gross revenues for that year. Implementing the New Rules.000. or from which the corporation received. and (e) a director who is employed as an executive of another entity where any of the company's executives serve on that entity's compensation committee. may be appointed to the audit committee. Interim Financial Information may be found at: http://www.org The information relating to the Blue Ribbon Committee was taken from a document developed by Ernst & Young titled. a majority of the members of which shall be independent directors (as defined above). if the board. and the board discloses. determines that membership on the committee by the individual is required by the best interests of the corporation and its shareholders. Independence Exception.aicpa. and Statement on Auditing Standards No. or $200.htm Statement on Auditing Standards No 90. One director who is not independent as defined above. under exceptional and limited circumstances. Goals are specific objectives of specific systems and may be otherwise referred to as operating or program objectives or goals. 2. Goals should be identified for each system. operation. 02. parts. 4. A system (process. measurable. however. Adequate control is present if management has planned and organized (designed) in a manner which provides reasonable assurance that the organization’s objectives and goals will be achieved efficiently and economically. Objectives are the broadest statements of what the organization chooses to accomplish. The scope of internal auditing work.) A system may also be a collection of subsystems operating together for a common objective or goal. This is followed by connecting or interrelating concepts. 1.60 UNIT 3: INTERNAL CONTROL Internal control encompasses the processes designed to provide reasonable assurances regarding the achievement of organizational objectives. activities. implementation. and/or people that are connected or interrelated to achieve objectives and goals. 3. function. targets. A. (This definition applies to both manual and automated systems. and they should explicitly recognize the risks associated with not achieving those objectives. The following is the complete text of IIA Standard 300: 300 SCOPE OF WORK THE SCOPE OF INTERNAL AUDITING SHOULD ENCOMPASS THE EXAMINATION AND EVALUATION OF THE ADEQUACY AND EFFECTIVENESS OF THE ORGANIZATION’S SYSTEM OF INTERNAL CONTROL AND THE QUALITY OF PERFORMANCE IN CARRYING OUT ASSIGNED RESPONSIBILITIES. or a collection of concepts. and consistent with established broader objectives. or expected results. performance levels. The purpose of the review for adequacy of the system of internal control is to ascertain whether the system established provides reasonable assurance that the organization’s objectives and goals will be met efficiently and economically. or activity) is an arrangement. The system design process begins with the establishment of objectives and goals. that senior management and the board provide general direction as to the scope of work and the activities to be audited. encompasses what audit work should be performed. planned activities should be executed as designed and expected results should be attained. activities. 01. as specified in this standard. and maintenance of systems whose purpose is to meet the organization’s objectives and goals. attainable. parts. If system design is properly performed. a set. IIA Standards for Internal Control Specific guidance for audit planning internal audits is given in IIA Standard 300. 60 . and/or people in such a manner as to operate together to achieve the established objectives and goals. operating standards. The establishment of objectives precedes the selection of goals and the design. They should be clearly defined. It is recognized. The accomplishment of established objectives and goals for operations or programs. in addition to accomplishing objectives and planned activities. 2. Directing involves. regulations. authorizing and monitoring performance. The reliability and integrity of information. d. Periodic comparison of actual to planned performance enhances the likelihood that activities occur as planned. and documenting these activities to provide additional assurance that systems operate as planned. The purpose of the review for effectiveness of the system of internal control is to ascertain whether the system is functioning as intended. that material errors and improper or illegal acts will be prevented or detected and corrected within a timely period by employees in the normal course of performing their assigned duties. Authorizing includes initiating or granting permission to perform activities or transactions. organizes. observing. Authorization implies that the authorizing authority has verified and validated that the activity or transaction conforms with established policies and procedures. a. 5. c. and testing activities and appropriately reporting to responsible individuals. Efficient performance accomplishes objectives and goals in an accurate and timely fashion with minimal use of resources. Compliance with policies. The cost-benefit relationship is considered by management during the design of systems. Effective control is present when management directs systems in such a manner as to provide reasonable assurance that the organization’s objectives and goals will be achieved. b. and standards of performance. The purpose of the review for quality of performance is to ascertain whether the organization’s objectives and goals have been achieved. Monitoring provides an ongoing verification of progress toward achievement of objectives and goals. Monitoring encompasses supervising. plans. and verification of planned performance. laws. 6. and directs the performance of sufficient actions to 61 . and contracts. This implies. The term efficient incorporates the concept of economical performance. for example.61 5. 05. compliance with policies. supervising. 4. The safeguarding of assets. Management plans. The economical and efficient use of resources. periodically comparing actual with planned performance. observing. 7. Economical performance accomplishes objectives and goals at a cost commensurate with the risk. 2. The primary objectives of internal control are to ensure: 1. and testing activities. 04. 3. 1. Documenting provides evidence of the exercise of authority and responsibility. procedures. 03. A control is any action taken by management to enhance the likelihood that established objectives and goals will be achieved. The potential loss associated with any exposure or risk is weighed against the cost to control it. 06. procedures. Reasonable assurance is provided when cost-effective actions are taken to restrict deviations to a tolerable level. and reports to establish the flow of data and the responsibilities of individuals for performing activities. 08. records. in the aggregate. Since internal auditors operate within an organization and. and activities within the organization are subject to the internal auditors’ evaluations. Management establishes and maintains an environment that fosters control. operational control. These variants differ primarily in terms of the objectives to be achieved. 62 . 1. periodically comparing actual with planned performance. no such distinction between internal and external controls is necessary. Such evaluations should encompass whether reasonable assurance exists that: a. organizing. etc. and directs in such a fashion as to provide reasonable assurance that established objectives and goals will be achieved.) can be incorporated within the generic term. internal accounting control. establishing information trails. operations. internal controls are all activities which attempt to ensure the accomplishment of the organization’s objectives and goals. management control. and appropriately documenting these activities. 07. procedures. organizing. 4. flowcharts. These activities include authorizing and monitoring performance. and directing by management.62 provide reasonable assurance that objectives and goals will be achieved. Internal auditors examine and evaluate the planning. from the organization’s viewpoint. among other responsibilities. Also. Planning and organizing involve the establishment of objectives and goals and the use of such tools as organization charts. organizes. The variant internal control came into general use to distinguish controls within an organization from those existing externally to the organization (such as laws). It is the integrated collection of controlled systems used by an organization to achieve its objectives and goals. processes. Directing involves certain activities to provide additional assurance that systems operate as planned. 1. Management ensures that its objectives and goals remain appropriate and that its systems remain current. Such evaluations. 2. Management plans. preventive control. 2. provide information to appraise the overall system of internal control. Controls may be preventive (to deter undesirable events from occurring). 3. All variants of the term control (administrative control. and directing processes to determine whether reasonable assurance exists that objectives and goals will be achieved. the methodology followed by internal auditors in evaluating such controls is consistent for all of the variants. Internal control is considered synonymous with control within the organization. The overall system of control is conceptual in nature. 4. participants in the control process should be familiar with the terms as well as their applications. All systems. 1. Objectives and goals have been established. control is the result of proper planning. or directive (to cause or encourage a desirable event to occur). functions. evaluate management’s response to external stimuli (such as laws). 3. detective (to detect and correct undesirable events which have occurred). Thus. Since these variants are useful in describing specific control applications. management periodically reviews its objectives and goals and modifies its systems to accommodate changes in internal and external conditions. internal control. 2. Therefore. However. output control. and setting standards of performance. Authorizing. and contracts. and should determine whether the organization is in compliance. applicable laws and regulations. The term compliance requirement refers to conditions established by management for the organization. and contracts. Plans. Internal auditors perform evaluations at specific points in time but should be alert to actual or potential changes in conditions which affect the ability to provide assurance from a forwardlooking perspective. or agreed to by contractual arrangement. monitoring. Compliance requirements include those established. including those intended to comply with laws. use. or agreed to for the purpose of safeguarding organization assets including prevention and/or detection of unauthorized acquisition. internal auditors should address the risk that performance may deteriorate. These conditions affect the manner in which an organization’s operations are conducted and objectives are achieved. laws. c. complete. laws. 1. Management is responsible for establishing the systems designed to ensure compliance with such requirements as policies. plans. Planned results have been achieved (objectives and goals have been accomplished). The term also refers to conditions which may be imposed on the organization by law or regulation. as appropriate. imposed. regulations. regulations. 2. ascertain whether: 1. Internal auditors are responsible for determining whether the systems are adequate and effective and whether the activities audited are complying with the appropriate requirements. performed. and compliance with external requirements. and periodic comparison activities have been planned. Therefore. Management is responsible for having knowledge of compliance requirements of all laws. regulations. internal auditors should examine information systems and. and procedures. a. plans. and report such information. The policies. procedures. plans. timely. and useful information.63 b. procedures. and contracts that are significant to achieving internal 63 . plans. 320 Compliance with Policies.05 of the Standards. 310 Reliability and Integrity of Information Internal auditors should review the reliability and integrity of financial and operating information and the means used to identify. The term compliance refers to the ability to reasonably ensure conformity and adherence to organization policies. Financial and operating records and reports contain accurate. Laws. Procedures. or disposition of resources. Management is responsible for designing and implementing policies. classify. 01. and Contracts Internal auditors should review the systems established to ensure compliance with those policies. Regulations. measure. plans. and contracts. and procedures designed and implemented by management should be sufficient to reasonably ensure prevention and/or detection of noncompliance with applicable laws. In those cases. procedures. reliable. and documented as necessary to attain objectives and goals. control. 3. Information systems provide data for decision making. 3. 4. Controls over record keeping and reporting are adequate and effective. regulations. and contracts applicable to the organization which are significant to achieving internal control objectives set forth in Section 300. 2. 01. regulations. and contracts which could have a significant impact on operations and reports. fire. Governmental or other regulatory authorities. In addition. 8.64 control objectives. Internal auditors should consider inquiring about significant compliance requirements with: a. and contracts. Significant noncompliance can also occur with respect to policies. and/or regulatory authorities. 01. Internal auditors are responsible for establishing objectives that include planning and performing a scope of work which provides a reasonable basis for reporting on the extent of organization compliance with policies. and oversight responsibilities. regulations. Significant noncompliance with laws. procedures. may violate laws. Management is responsible for setting operating standards to measure an activity’s economical and efficient use of resources. operational. or contracts may constitute illegal acts. Such performance may provide insight as to the existence and impact of exposure to significant instances of noncompliance. should use appropriate audit procedures. plans. 6. Internal or external legal counsel. plans. when verifying the existence of assets. 02. management is responsible for initiating such corrective actions necessary to achieve compliance. and/or constitute illegal acts. Organization management having financial. 330 Safeguarding of Assets Internal auditors should review the means of safeguarding assets and. Funding or contracting organizations. funding. Management is responsible for determining whether noncompliance brought to its attention by internal auditors. 7. as appropriate. and contracts that are significant to internal control objectives. and procedures in which no law or regulation is involved. laws. improper or illegal activities. 340 Economical and Efficient Use of Resources Internal auditors should appraise the economy and efficiency with which resources are employed. b. or contractual agreements. This may require reporting by management to the board and appropriate legal. regulations. and exposure to elements. e. c. verify the existence of such assets. internal auditors should make inquiry regarding specific compliance requirements that are significant to internal control objectives. In determining audit objectives. as described in Section 280 of the Standards. b. External auditors. 01. 5. d. Internal auditors are responsible for determining whether: 64 . regulations. regulations. Internal auditors should promptly inform senior management and the board of all relevant facts when information gathered from the performance of internal auditing procedures indicates the existence of significant noncompliance or an unreasonable exposure to significant instances of noncompliance. or by discovery. Internal auditors should review the means used to safeguard assets from various types of losses such as those resulting from theft. Internal auditors. Internal auditors may perform additional procedures which provide insight with respect to compliance with laws. When a program is completed. Nonproductive work. spanning several years. developing and implementing control procedures. such as: 65 .65 1. 4. 02. Underutilized facilities. internal auditors should use such criteria for evaluation if they are considered adequate. and special purpose government grants. Management is responsible for establishing criteria to determine if objectives and goals have been accomplished. 3. internal auditors may recommend appropriate courses of action depending on the circumstances. Special purpose activities may be short-term or long-term. 2. Corrective action has been taken. The term programs refers to special purpose activities of an organization. Management is responsible for establishing operating or program objectives and goals. Program results may be measured against established program objectives and goals. but are not limited to. Such activities include. and governmental assistance. are less than adequate. or if the established criteria. 6. Internal auditors should ascertain whether criteria have been established. finance and accounting. it generally ceases to exist. Established operating standards are understood and are being met. marketing. internal auditors should report such conditions to the appropriate levels of management. human resources. new product or service introduction campaigns. capital expenditures. purchasing. If so. time or production schedules. but are not limited to. Overstaffing or understaffing. 3. Additionally. and accomplishing desired operating or program results. Audits related to the economical and efficient use of resources should identify such conditions as: 1. production. An operation’s results may be measured against established objectives and goals which may include budgets. 4. 2. 01. analyzed. The term operations refers to the recurring activities of an organization directed toward producing a product or rendering a service. Such activities may include. 4. 350 Accomplishment of Established Objectives and Goals for Operations or Programs Internal auditors should review operations or programs to ascertain whether results are consistent with established objectives and goals and whether the operations or programs are being carried out as planned. 2. 3. If management has not established criteria. and/or operating plans. in the internal auditors’ opinion. Procedures which are not cost justified. Deviations from operating standards are identified. sale of a facility. sales. 1. the raising of capital. Operating standards have been established for measuring economy and efficiency. Internal auditors may recommend alternative sources of criteria to management. fund-raising campaigns. Internal auditors should ascertain whether such objectives and goals conform with those of the organization and whether they are being met. 5. and communicated to those responsible for corrective action. An operation or program is in compliance with policies. d.66 a. Controls for measuring and reporting the accomplishment of objectives and goals are established and are adequate. goals. The report should state the criteria established by management and employed by internal auditors and disclose the nonexistence or inadequacy of any needed criteria. If internal auditors formulated criteria by which to measure the accomplishment of objectives and goals. procedures. c. internal auditors may still formulate criteria they believe to be adequate in order to perform an audit. form an opinion. current. or conflicts with other operations or programs. b. Internal auditors should communicate the audit results to the appropriate levels of management. overlaps. and regulations. f. management. Audit objectives may include determining whether: a. Management has considered alternatives for directing an operation or program which may yield more effective and efficient results. 9. SAS 55 and 78 (AU Section 319. and relevant information is being used. e. 7. 8. and controlled in an appropriate manner. g. and issue a report on the accomplishment of established objectives and goals. the report should clearly state that internal auditors formulated the criteria and then present the audit results. b. If adequate criteria are not established by management. plans. Standards in law and government regulations. Summary of AICPA Standards for Internal Controls 1. and whether suitable controls have been incorporated into the operations or programs. The objectives and goals established by management for a proposed. evaluated. The operation or program achieves its desired level of interim or final results. laws. whether accurate. and systems by determining whether the underlying assumptions are appropriate. c. Acceptable industry standards. 02. duplicates. Standards developed by professions or associations. new. The factors which inhibit satisfactory performance are identified. An operation or program complements. B. and other personnel designed to provide reasonable assurance regarding the achievement of objectives in the following categories: 66 . Internal auditors can provide assistance to managers who are developing objectives.06) define internal control as the process effected by an entity’s board of directors. The internal auditors’ evaluation of the accomplishment of established objectives and goals may be carried out with respect to an entire operation or program or only a portion of it. or existing operation or program are adequate and have been effectively articulated and communicated. 67 a. For example. however. 67 . These organizations often have effective personnel policies and a “code of conduct. Organizations that foster an ethical environment and promote compliance with internal controls. The control environment is often a function of the “organizational culture” and is usually only as strong as the ethics and attitudes of those in charge of implementing internal controls.relating to the preparation of reliable published financial statements. The risks associated with operating objectives include the business climate.” A strong training program is also a key ingredient. SAS 55 and 78 (AU Section 319. Elements and Types of Internal Control 1. and practices to ensure that basic internal controls (such as segregation of duties) are present. These are often more difficult to implement since compliance may actually negatively impact financial goals in the short term. Internal auditing can also have a positive impact as it assists in preventing and detecting invalid transactions and statements. b.32) identify five internal control components: a. Internal audit also reviews compliance with accepted policies.relating to the effective and efficient use of the entity’s resources. The effective management of business risk can help increase the profitability of an organization. technology. and legislation. C. There are also risk associated with compliance with laws and regulations. For example. have a solid foundation. procedures. For risk management controls to be implemented.relating to the entity’s compliance with applicable laws and regulations. noncompliance with environmental regulations may seem cost-effective in the current quarter. Operational controls . Financial reporting controls . some retail organizations have found that training programs to identify instances of fraud and theft and the associated penalties have reduced the instances of fraud and theft in sales and cashier positions. operating objectives must be instituted and be reasonably obtainable. c. the fines and associated negative publicity could have severe long term consequences. customer requirements. especially through top management. competitors. Compliance controls . Control Environment forms the foundation for the other internal control components. b. Risk Assessment is the process of assessing the inherent risks associated with achieving business goals. 000. The efforts to control both risk types will enhance the short.controls over the actual processing of the information. for example). Employees must be aware of and implement the accepted control procedures. Training programs are also an excellent means to ensure employees understand their responsibility. c. therefore. They also help ensure that necessary actions are taken to assess the risks associated with the achievement of management’s objectives. categorizes.controls the dissemination of the information either in hard copy or electronic format. For example. More complex edit checks include ranges (maximum monthly salary of $15. the edit checks and other input controls are critical. The basic controls include: • Input .68 Internal audit routinely reviews compliance risk and also should be reviewing business risk. a Social Security Number must be 9 characters and numeric. In today’s environment. In today’s environment. Therefore. information systems has become analogous to computer system. the controls associated with the integrity and security of computer systems have a direct impact on the validity of information. Awareness can be communicated through formal policies and procedures and through the requirements outlined in job descriptions. output . Management needs to receive the necessary reports and information to determine if organizational objectives are being met. These controls ensure that valid data will be processed and produce expected and valid results. Often these reports are generated from an information system and should be sufficiently detailed to management to carry out their responsibilities. Information and communication is critical to ensuring the effectiveness of an internal control system. Reports must be readable and understandable and those that contain sensitive information must be adequately safeguarded. Edit checks are defined as the programmed edits that permit or prevent the input of invalid data. Control activities are the policies and procedures that assist management in ensuring that objectives are carried out. The programming that manipulates. 68 . d. a paper-based source document may not be available due to real time data entry.controls over the entry of information from source documents. • • Communication of internal requirements is a key concern for external auditors because the internal control structure has an impact on the financial statements and associated audit opinion.and longterm profitability and viability of an organization. processing . for example) or other logical groupings. or summarizes the data (financial transactions. Internal auditors generally perform these in-depth evaluations of internal control systems. all transactions should be reviewed and approved by someone other than the person entering the transaction. must be in place. review.69 Control activities are designed to prevent and detect errors in financial transactions and to promote accurate financial statements. and approved prior to being incorporated into the financial statements. pre-numbered documents . including controlling changes to programs. Frequent verification and reconciliation of the pre-numbered forms must be conducted.such as online edit checks (that test validity of data for reasonableness. documentation. In addition controls over systems development. frequent review of activities . controlled adjustment and error processing . spot checks are often performed by supervisory staff in specific areas. Even the best system of internal controls must be continually reviewed to ensure that the activities are being followed and continue to meet organizational needs.) to ensure that data meets basic parameters. In many instances these reviews may be performed internal audit staff. Segregation of duties would prevent one person from misappropriating assets and the concealing the crime by making false entries into accounting records. • • • • • The control activities listed above are some of the basic processes and procedures that help establish the framework for an effective system of internal control over financial activities. These would also include reviews of inventory. some of the more common ones include: • segregation of duties . This includes the review and re-processing of data that had errors in the initial entry of the data.to ensure that policies and procedures are being followed.to ensure that adjustments are recorded.help ensure that financial documents cannot be taken and used inappropriately without detection. computer controls . e. accounting records. Beyond routine activities of monitoring (such as comparing budget to actual performance) more extensive evaluations of the internal control system should be conducted. reviewed. Some of the routine monitoring activities may include: 69 . however. etc.all financial transactions should be documented and have a sufficient audit trail. transaction logs. In addition. etc. Monitoring is the process of reviewing internal controls to ensure that they are effective.ensures that accounting staff and payment staff (those that have access to financial assets) do not have access to the records or assets controlled by the other group. limits. Although there are numerous separate and distinct control activities. and approval of transactions . etc. subsequently. Identify the control points that exist in the system. There are four steps in evaluating internal controls: a. identify that weaknesses exist in the internal control environment. In some instances. disbursement. segregation of the accounts payable. an understanding of the internal control system must be obtained. This includes reviewing the internal control system to determine the probability of material misstatements or the potential for fraud. D. the financial statements. determine whether the necessary controls to prevent misstatement and fraud have been developed. c. report significant weaknesses to the auditee. design tests to reflect the weaknesses identified in the internal control environment. a compensating control may exist. b. and accounting functions would be a control point. 2. the accepted or expected control may not exist. Therefore. 3. product inventory. including: 70 . In the previous example. This segregation would prevent a fraudulent payment transaction unless collusion was involved. an auditor may determine that a sufficient compensating control exists.70 • • • • • monthly bank reconciliations cash register audit to verify that cash and cash register tapes are reconciled periodic inventory of assets (cash. Evaluation of the System of Internal Control 1. d. Sufficient documentation can come in a variety of forms. Auditors need to review the system of internal control to: a. if the functions were not segregated but an independent person reviewed and approved all payments. determine whether the necessary controls to prevent misstatement and fraud have been implemented. equipment.) review of accounts payable for appropriateness follow-up on customer inquiries regarding exceptions to billing statements. b. e. however. to effectively plan for an audit. Since the internal control environment has a significant impact on the integrity of transactions and. For example. the internal control environment must be evaluated. Document an understanding of the control environment. a document that is similar to a questionnaire that contains less narrative and more yes/no questions. and report financial data consistent with the assertions of management in the financial statements. Assess the level of control risk. The AICPA (AU Section 325. In most instances. c. failure to safeguard assets from loss. flowchart . A flowchart is an excellent way to document the control environment in an understandable format. should be communicated to the audit committee because they represent significant deficiencies in the design or operation of the internal control (system). 2. extensive substantive testing will be necessary to determine the validity of transactions and data. auditors may assess control risk at maximum (even though the internal control system appears strong) to increase the testing levels to verify the integrity of transactions and data. This assessment will determine the necessary level of substantive testing. checklists . control points. 4.71 1. Some examples of reportable conditions include: a.a document that follows a prescribed format where specific questions are asked and answers are placed directly on the form. a checklist does not provide sufficient documentation unless accompanied with a memorandum. evidence of fraudulent activities by employees or management c.02) defines reportable condition as: Matters coming to the attention of auditor’s attention. questionnaires . 3. process. Communicate reportable conditions to management. In some cases. damage or misappropriation 71 . and weaknesses in a narrative format. which could adversely affect the organization’s ability to record. Control risk can range from minimum (effective controls exist) to maximum (limited controls exist). If control risk is maximum.a document that outlines in visual and narrative format the processes and control points within the process. In any case. memorandums . d. any decisions relating to the assessment of control risk must be thoroughly documented.documents that outline the control environment. that in his/her judgment. This approach works best when it is supplemented with a memorandum. the need for substantive tests is greatly reduced. failure to correct reportable conditions identified in prior engagements d. The level of control risk can be modified during testing if test results indicate that a change is warranted. summarize. lack of appropriate segregation of duties b. If minimum is selected. the payments were not properly recorded or disclosed in financial reports. The Treadway Commission developed an internal control framework called the Internal Control – Integrated Framework. The Committee on Sponsoring Organizations (COSO) was a private-sector initiative started in the 1980s to address the problem of fraudulent financial reporting. These scandals led to the enactment of the Foreign Corrupt Practices Act of 1977. the Institute of Internal Auditors. however. some corporations made significant payments to foreign entities to secure contracts and business opportunities. The initial project was the Treadway Commission Report. 2. and provides criteria against which control systems can be evaluated. and others can use to evaluate an internal control system. if they are identified. issued in October 1987. and the Institute of Management Accountants. internal controls. auditors. and ethical standards. 3. operational efficiency and economy. 4. The report also recommended a public management report describing management’s responsibility for a company’s financial statements and internal controls. Problems continued to persist in the 1980s and the private sector was wary of additional government intervention. and compliance with rules. 6. It offers guidance for public reporting on internal control and provides materials that management. The Framework promotes the concept that effective internal control is management’s responsibility and requires the participation of all persons within an organization if it is to be effective. so five organizations banded together to form COSO: the American Institute of CPAs. Internal Control Integrated Framework (COSO) 1. describes its components. the American Accounting Association. and an assessment of the internal control system. While financial reporting is an important responsibility of the audit committee. It should be noted that auditors are not required to search for and/or identify reportable conditions. The Framework defines internal control broadly and does not limit internal controls to accounting controls over financial reporting. 5. and policies that are also important. Two major goals of COSO were to: 72 .72 e. The Treadway Commission Report called for an adequate system of internal control. COSO defines internal control. For example. there are other very important aspects of the business relating to resource protection. regulations. However. evidence of system flaws that fail to provide complete and accurate information. E. Reportable conditions are often called material weaknesses and are reported to management in a formal letter. In the 1970s there were a number of scandals that called into question the integrity of corporate financial reporting. the Financial Executives Institute. they must be reported to management. COSO’s mission was to improve the quality of financial reporting through a focus on corporate governance. The concept of self assessment is included in COSO and many other documents that provide guidance on internal control activities.aicpa. but not a substitute for. Although the report defines internal control as a process. operating activities. management. establish a common definition of internal control b. For additional information on COSO. designed to provide reasonable assurance regarding the achievement of objectives in the following categories: a. errors. effected by an entity's board of directors.org/news/p032699b. etc. 3. compliance with applicable laws and regulations 8.) to develop procedures to adequately control their functions. rather than built onto. manufacturing. accounting. collusion. every organization should make a self-assessment of its control system. An objective of the initial self assessment is to provide insight into how to proceed with a more in-depth evaluation of the internal control system. payroll. the internal control system is far more likely to be effective. To ensure that internal controls exist and are operating properly. Self assessment places responsibility on the organization and individuals responsible for key areas (sales. it recommends evaluating the effectiveness of internal control as of a point in time. and cost/benefit considerations.htm F. provide a standard against which organizations can assess their control systems 7. management and that controls should be built into. As a result. and other personnel. 4. reliability of financial reporting c. Limitations include faulty human judgment. internal and external 73 . If responsibility for controls is clearly delineated to key staff. access this web site: http://www. 9. misunderstanding of instructions. Control Self Assessment 1. COSO emphasizes that the internal control system is a tool of. 2.73 a. COSO has a similar definition of internal control as the AICPA and defines internal control as: a process. The self-assessment may be made in specific areas deemed to be of high risk by senior management rather than across the board. COSO also addresses the limitations of an internal control system and the roles and responsibilities of the parties that affect a system. effectiveness and efficiency of operations b. management override. more importantly. the likelihood of inaccurate financial reporting is greatly diminished.74 auditors can place more reliance on the internal control system. 74 . and. Generally. taken together. b. 75 . The internal auditor is responsible for planning and conducting the audit assignment. define the scope of the internal auditor’s work. A. IIA Standards for Audit Planning Specific guidance for audit planning internal audits is given in IIA Standard 400-410 and 520. Audit objectives and procedures. The guidelines contained in Sections 520. .75 UNIT 4: AUDIT PROCESS The audit process encompasses all of the aspects of an audit from the inception through the development of the final product. COMMUNICATING RESULTS. audit planning involves gathering background information about the audit area.01 Planning should be documented and should include: . 01. Audit procedures are the means to attain audit objectives.1 Establishing audit objectives and scope of work.. Audit standards have been developed to guide the process and promote an objective and quality product. subject to supervisory review and approval. .1 . AND FOLLOWING UP. c. The purpose of the risk assessment during the planning phase of the audit is to identify significant areas of the auditable activity.2 Obtaining background information about the activities to be audited.04. AUDIT PLANNING All audit work should be adequately planned. Audit objectives are broad statements developed by internal auditors and define intended audit accomplishments. Audit objectives and procedures should address the risks associated with the activity under audit.14 of the Standards should be used by internal auditors to assess risk for individual audit assignments. 410 Planning the Audit Internal auditors should plan each audit. EXAMINING AND EVALUATING INFORMATION. The term risk is the probability that an event or action may adversely affect the activity under audit. and preparing an audit program. I. defining the audit’s scope and objectives. The following is the complete text of IIA Standard 400-410 and 520: 400 PERFORMANCE OF AUDIT WORK AUDIT WORK SHOULD INCLUDE PLANNING THE AUDIT. a. e. and disciplines are needed. since proper planning at this stage facilitates writing the final audit report. A review of background information should be performed to determine the impact on the audit. The final audit report format should be considered. job descriptions. regulations. skills. Such items include: • • • Objectives and goals. completed or in process. should be determined. Organizational information.76 a. a. a..4 Communicating with all who need to know about the audit. and disciplines of the internal auditing staff should be considered in selecting internal auditors for the audit assignment. . Policies. . d. The number and experience level of the internal auditing staff required should be based on an evaluation of the nature and complexity of the audit assignment. time constraints. • • • • • b. and available resources.g. Other requirements of the audit. c. such as the audit period covered and estimated completion dates. Topics of discussion may include: • • • Planned audit objectives and scope of work. including the work of external auditors. Correspondence files to determine potential significant audit issues. 76 . operating results.3 Determining the resources necessary to perform the audit. number and names of employees. plans. Knowledge. Internal auditors assigned to the audit. and financial data of the activity to be audited. Results of other audits. key employees. and details about recent changes in the organization. Authoritative and technical literature appropriate to the activity. Consideration of the use of external resources in instances where additional knowledge. laws. skills. and contracts which could have a significant impact on operations and reports. Meetings should be held with management responsible for the activity being examined. Prior audit workpapers. since each audit assignment serves as a basis for meeting developmental needs of the internal auditing department. b. including major system changes. The timing of audit work. Budget information. procedures. Training needs of internal auditors should be considered. the type of audit being performed.g. Description of the internal auditing department’s reporting procedures and follow-up process. Time requirements will also be influenced by the size and complexity of the activity being examined. as appropriate. On-site observations. as appropriate.77 • • • • • The process of communicating throughout the audit. . Obtain information for use in performing the audit. A survey may involve use of the following procedures: • • • • • Discussions with the auditee. The main purposes are to: • • • • b. A survey is a process for gathering information. d. without detailed verification. The scope of work and the time requirements of a survey will vary. time frames..5 Performing. c. A summary of matters discussed at meetings and any conclusions reached should be prepared. and by the geographical dispersion of the activity. Determine whether further auditing is necessary. and is an effective tool for applying the internal auditing department’s resources where they can be used most effectively. including the methods. a survey to become familiar with the activities. including recent changes in management or major systems. risks. and to invite auditee comments and suggestions. distributed to individuals. 77 . Analytical auditing procedures. e. A survey permits an informed approach to planning and carrying out audit work. Business conditions and operations of the activity being audited. and individuals who will be responsible. e. The focus of a survey will vary depending upon the nature of the audit. Review of management reports and studies. Concerns or any requests of management. and retained in the audit workpapers. b. Contributing factors include the internal auditor’s training and experience. on the activity being examined. knowledge of the activity being examined. and controls to identify areas for audit emphasis. a. Identify significant areas warranting special emphasis. Interviews with individuals affected by the activity. and whether the survey is part of a recurring or follow-up assignment. users of the activity’s output. Matters of particular interest or concern to the internal auditor. Understand the activity under review. A summary of results should be prepared at the conclusion of the survey. systems. They should be accompanied by measurement criteria and targeted dates of accomplishment. 3. (c) potential loss and risk. 2. Matters to be considered in establishing audit work schedule priorities should include (a) the date and results of the last audit. Audit objectives. Potential critical control points. Preliminary estimates of time and resource requirements. 03. Goals. (d) requests by management. and/or excess controls. Documenting key control activities. Staffing plans and financial budgets. and (g) changes to and capabilities of the audit staff. programs. to the extent possible. reasons for not continuing the audit. (b) financial exposure. taking into account the scope of the audit work planned and the nature and extent of audit work performed by others. 520 Planning The director of internal auditing should establish plans to carry out the responsibilities of the internal auditing department. and (c) the estimated time required. should be measurable. (e) major changes in operations. 4. Flowcharting. Audit work schedules should include (a) what activities are to be audited. Activity reports. Pertinent information developed during the survey. 01. Revised dates for reporting phases and completing the audit. These plans should be consistent with the internal auditing department’s charter and with the goals of the organization. (b) when they will be audited. audit procedures. 02. When applicable.78 • • • f. Functional "walk-through" (tests of specific work activities from beginning to end). and controls. The goals of the internal auditing department should be capable of being accomplished within specified operating plans and budgets and. The summary should identify: • • • • • • • Significant audit issues and reasons for pursuing them in more depth. 78 . Audit work schedules. control deficiencies. (f) opportunities to achieve operating benefits. 04. and special approaches such as computer-assisted audit techniques. The work schedules should be sufficiently flexible to cover unanticipated demands on the internal auditing department. The planning process involves establishing: 1. Staffing plans and financial budgets. 5. in some accounting systems. The availability of data. In addition.04. 3. administrative activities. An entity’s data retention policies may require the auditor to request retention of some information for review or to perform audit procedures at a time when the information is available. education and training requirements. and audit research and development efforts. In some computer systems. AICPA Standards for Planning Audits that Involve Computers SAS 22 (AU Section 311) provides additional guidance when planning an audit that involves computer-generated information or the use of computer-assisted audit techniques. input documents may not exist at all because information is directly entered into the system.79 Note: The full text of Sections 520. and other evidential matter that may be required by the auditor may exist only for a short period or only in the computer-readable form. it may be difficult or impossible for the auditor to analyze certain data or test specific control procedures without computer assistance. 79 . The extent to which the computer is used in each significant accounting application. skills. including the use of an outside service center. and disciplines required to perform their work. In addition. certain information generated by the computer for management’s internal purposes may be useful in performing substantive tests. 4. B. certain computer files. Activity reports should be submitted periodically to senior management and to the board. should be determined from audit work schedules.14 are printed in Unit 5 05. 2. Documents that are used to enter information into the computer for processing.1 – 520. The organizational structure of the computer processing activities.04. The complexity of the entity’s computer operations. The use of computer-assisted audit techniques to increase the efficiency of performing audit procedures. including the number of auditors and the knowledge. 06. Using computer-assisted audit techniques may also provide the auditor with an opportunity to apply certain procedures to an entire population of accounts or transactions. They should explain the reason for major variances and indicate any action taken or needed. These reports should compare (a) performance with the department’s goals and audit work schedules and (b) expenditures with financial budgets. This statement suggests that auditors should consider matters such as: 1. Be prepared prior to the commencement of audit work and modified. Adjustments to audit work plans should be approved in a timely manner.6 Writing the audit program. during the course of the audit.6-410. to the extent deemed practical. a. when. B. and to whom audit results will be communicated. and transactions which should be examined. Audit programs should: • • • • • • Document the internal auditor’s procedures for collecting. and documenting information during the audit.6-410.8. a. IIA Standards for Writing the Audit Program Specific guidance for audit planning internal audits is given in IIA Standard 410.80 II. b.8 Obtaining approval of the audit work plan. analyzing. risks. during the planning phase of the audit. as appropriate. Set forth the scope and degree of testing required to achieve the audit objectives in each phase of the audit. if appropriate. Subsequent changes which affect the timing or reporting of audit results should also be communicated to management. A. State the objectives of the audit. a. interpreting. processes. if factors preclude obtaining written approval prior to commencing audit work. 410. The following is the complete text of IIA Standard 410. AUDIT PROGRAMS Audit programs are designed to document the audit objectives decided upon during the planning phase of the audit. 410.7 Determining how. Functions of Audit Programs 80 . The director of internal auditing is responsible for determining how. In addition. Audit work plans should be approved in writing by the director of internal auditing or designee prior to the commencement of audit work. Initially. the audit program documents the methods and procedures assigned auditors will use to achieve the audit objectives. and to whom audit results will be communicated.8: 410. approval may be obtained orally. State the nature and extent of testing required. when. This determination should be documented and communicated to management. Identify technical aspects. IIA Standards for Workpapers Specific guidance for audit planning internal audits is given in IIA Standard 420. the names and numbers of key auditee contacts 5. Audit programs provide an opportunity to determine whether sufficient staff and resources are available to adequately satisfy the audit objectives. However.5. workpapers represent a record of the work performed and the conclusions reached during the audit.5: 81 . and methodology. The extent of the audit program will vary depending on the size and complexity of the area audited. Audit programs provide a written record of the audit objectives. Contents of Audit Programs The extent and type of information included in an audit program will vary depending on the nature of the assignment and the assigned auditors’ knowledge of and experience with the audit area. AUDIT WORKPAPERS Workpapers are the basic medium on which audit evidence is recorded and stored. The specific form and content of workpapers will vary according to the complexity and nature of individual audits. The following is the complete text of IIA Standard 420. C. Audit programs should be flexible enough to incorporate necessary changes as the audit progresses. Audit programs document the agreed upon objectives and overall strategy for the audit. 4. a listing of staff assigned to the audit and their qualifications III. audit programs may include the following: 1. a timeline for completing the various audit phases and the final report 7. background information about the audit area 2. Therefore. 2. specific audit tasks for auditors to carry out the audit objectives 6. Workpapers may be prepared manually or by computer. 3. A. and the auditors’ reasons for these decisions. a list of relevant past audit findings 4.81 1. discussion of relevant legal issues 3. scope. c. such as organization charts and job descriptions. Aid in the planning. Provide support in circumstances such as insurance claims. The auditing procedures performed. however. d. and content of audit workpapers will depend on the nature of the audit. performance. Aid in the professional development of the internal auditing staff. document the following aspects of the audit process: • • • • • • Planning. the information obtained. checklists. a. and lawsuits. Reporting. Copies of important contracts and agreements. Notes and memoranda resulting from interviews. Organizational data. 82 . audit workpapers may include: • • • • • Planning documents and audit programs. Provide a basis for evaluating the internal auditing department’s quality assurance program. These papers should record the information obtained and the analyses made and should support the bases for the findings and recommendations to be reported. Document whether the audit objectives were achieved. Audit workpapers should be complete and include support for audit conclusions reached. Follow-up. Among other things. design.5 Workpapers that document the audit should be prepared by the auditor and reviewed by management of the internal auditing department. The organization. b. Audit workpapers generally serve to: • • • • • • • • • Provide the principal support for the internal audit report. flowcharts. Demonstrate the internal auditing department’s compliance with the Standards for the Professional Practice of Internal Auditing. Audit workpapers should. Control questionnaires.82 420. and narratives. and review of audits. The examination and evaluation of the adequacy and effectiveness of the system of internal control. Facilitate third-party reviews. fraud cases. Review. and the conclusions reached. h. The audit report and management’s responses. If audit workpapers are in the form of media other than paper. Each audit workpaper should be signed (or initialed) and dated by the internal auditor. Audit verification symbols (tick marks) should be explained. diskettes. and the date or period covered by the audit. Results of analytical auditing procedures. processes. Audit workpapers may be in the form of paper. a title or description of the contents or purpose of the workpaper. Evidence of supervisory review should be documented in the audit workpapers. Audit correspondence if it documents audit conclusions reached.83 • • • • • • • e. consideration should be given to generating backup copies. the audit workpapers should document whether the accounting records agree or reconcile with such financial information. 83 . or other media. Some audit workpapers may be categorized as permanent or carry-forward audit files. Analysis and tests of transactions. The director of internal auditing has overall responsibility for review but may designate appropriately experienced members of the internal auditing department to perform the review. indexing and other related matters. The director of internal auditing should establish policies for the types of audit workingpaper files maintained. disks. k. The following are typical audit working-paper preparation techniques: • Each audit workpaper should contain a heading. stationery used. Information about operating and financial policies. These files generally contain information of continuing importance. Each audit workpaper should contain an index or reference number. All audit workpapers should be reviewed to ensure that they properly support the audit report and that all necessary auditing procedures have been performed. Standardized audit workpapers such as questionnaires and audit programs may improve the efficiency of an audit and facilitate the delegation of audit work. • • • • j. Evidence of supervisory review should consist of the reviewer initialing and dating each workpaper after it is reviewed. and account balances. g. Sources of data should be clearly identified. The heading usually consists of the name of the organization or activity being examined. films. f. i. If internal auditors are reporting on financial information. Letters of confirmation and representation. tapes. Results of control evaluations. p. and results of the review. Acceptable alternatives with respect to disposition of review notes are as follows: — Retain the review notes as a record of the questions raised by the reviewer and the steps taken in their resolution. Audit working-paper files should generally remain under the control of the internal auditing department and should be accessible only to authorized personnel. n. The director of internal auditing should develop retention requirements for audit working papers. — Discard the review notes after the questions raised have been resolved and the appropriate audit workpapers have been amended to provide the additional information requested. These requests for access should be subject to the approval of the director of internal auditing. q. B. extent. the director of internal auditing should obtain the approval of senior management and/or legal counsel. Audit workpapers are the property of the organization. Access to audit workpapers by external auditors should be subject to the approval of the director of internal auditing. r. When clearing review notes. Such access may be necessary to substantiate or explain audit findings or to utilize audit documentation for other business purposes. Other review techniques that provide evidence of supervisory review include completing an audit working-paper review checklist and/or preparing a memorandum specifying the nature. Management and other members of the organization may request access to audit working papers. Purposes of Workpapers Workpapers are: 1. care should be taken to ensure that the workpapers provide adequate evidence that questions raised during the review have been resolved. and recommendations contained in the audit report 84 . s. as appropriate. These retention requirements should be consistent with the organization’s guidelines and any pertinent legal or other requirements. Reviewers may make a written record (review notes) of questions arising from the review process. It is common practice for internal and external auditors to grant access to each other’s audit workpapers. Documentation of work performed during the audit 3. Support for the information. o. m. A record of the purpose and scope of the audit 2. There are circumstances where requests for access to audit workpapers and reports are made by parties outside the organization other than external auditors. Prior to releasing such documentation.84 l. conclusions. The auditor preparing the workpaper should be primarily responsible for its format. Date or period covered d. Support for discussions with management about the organization’s operations and controls 8. 3. content. concise. who performed the audit work. Name of the auditee and/or the specific area being audited b. and who reviewed the work.85 4. Workpapers may contain the following information: a. Source of the information 85 . Workpapers should be so clearly prepared that it would be possible. They should leave a clear. Workpapers should be complete and accurate. Workpapers should be legible and neat in order to facilitate prompt and thorough supervisory review. A source of information that aids continuity when audit staff changes 9. 2. rather than just represent a collection of random information. to allow a third party to reconstruct the tests and analyses that have been performed. Documentation to facilitate external reviews by providing evidence that auditors complied with audit standards when conducting the audit C. Subsequent reviews by others should not relieve the initial preparer of this responsibility. and adequate record that fully documents the audit procedures followed. A basis for management to evaluate the auditor’s technical ability and proficiency 11. 5. A source for determining additional areas that may require testing 6. A means of collecting and organizing data into manageable components 7. Workpapers should be relevant and orderly. 4. Subject of the workpaper c. even years later. and accuracy. A tool for monitoring progress during the audit by showing what work has been completed and what work remains 5. Basic Workpaper Guidelines 1. A data source for future reference 10. Signature or initials of the preparer g. including: 1. Previous audits. Interview write-ups 4. Sampling plans 8. Use footnotes or other identifying explanations to annotate workpapers as necessary for a clear understanding of the work performed. Flow charts 9. Observations 86 . Index or reference number j. Legal Information 7. Policies and procedures 6. responses. Type of Information Typically Contained in the Workpapers The workpapers should contain everything that is pertinent to the work being performed and to understanding how the work was planned and carried out.86 e. and results of follow-up 11. Purpose of the workpaper f. Supporting data 12. D. Evidence of supervisory review i. Correspondence 3. Memoranda 5. Date prepared h. Results of tests 13. Cross indexes to audit program or other workpapers 6. Questionnaires 10. Audit programs 2. including the testing and sampling techniques employed. Use of Evidence to Support Audit Findings 87 . 3. informed person would reach the same conclusions as the auditor. c. Workpapers provide a record of audit information for use in planning and carrying out subsequent audit assignment. b. relevant.3 Audit procedures.4. B. Workpapers assist audit supervisors in monitoring and controlling audits (e.2 . and documenting information should be supervised to provide reasonable assurance that the auditor’s objectivity is maintained and that audit goals are met. d.87 E. and useful to provide a sound basis for audit findings and recommendations. A. and determining compliance with audit standards).4 The process of collecting. where practicable. The Role of Workpapers in Audit Supervision 1. and convincing so that a prudent.g. Evidence is gathered by using analytical auditing procedures. competent. and expanded or altered if circumstances warrant. Sufficient information is factual. IIA Standards for Audit Evidence Specific guidance for audit evidence is given in IIA Standards 420. interpreting. . AUDIT EVIDENCE Auditors accumulate evidence during fieldwork to fulfill the audit objectives and to support audit findings. 2.2 Information should be sufficient.. should be selected in advance. Useful information helps the organization meet its goals. Relevant information supports audit findings and recommendations and is consistent with the objectives for the audit. IV. organizing staff assignments. establishing quality control. Workpapers provide a basis for auditor evaluations. . Competent information is reliable and the best attainable through the use of appropriate audit techniques. a. adequate. The following is the complete text of these IIA Standards: 420. analyzing.420. A signed contract. only evidence which is considered “proof of fact” would be included in this category. 3. However. Types of Evidence There are four categories of evidence: documentary evidence. in cases where the validity of the documentation is in doubt. the evidence may be downgraded to secondary. C. and questionnaires. and interpretations made by the auditor. property. This type of evidence cannot support a finding or conclusion by itself. Interview information critical to the audit should be corroborated when possible by examining records or other information. corroborative evidence should be obtained. for example. Analytical Evidence is evidence compiled by the auditor from other types of evidence. ledgers. surveys. the specific use the evidence and the importance of the finding determine whether such evidence is considered primary or secondary. Inspection or observation is used for: 88 . contracts. 1. Documentary Evidence is usually the most reliable type of evidence. 2. or samples. 4. Secondary of Indirect Evidence provides less certainty in supporting a finding or conclusion. Generally. 3. 2. Analytical evidence includes calculations. Testimonial Evidence consists of information obtained from individuals through oral or written statements. Documentation such as letters. and physical evidence. The quality of analytical evidence depends on the quality of the data used and the quality of the analysis performed. auditors relying on analytical evidence should fully document the analytical procedure used. analytical evidence. testimonial evidence. if there is doubt as to the authenticity of the signatures. maps.88 Evidence can be classified in three broad categories according to its value in supporting a conclusion: 1. Testimonial evidence includes interviews. Typical examples of secondary evidence include interviews and internally prepared documents. or events. Corroborative Evidence is additional evidence in support of primary or secondary evidence. invoices. photographs. and canceled checks are generally very reliable and objective sources of evidence. Auditors should ask themselves whether their source of information is free from bias and whether the individual is in a position to be truly knowledgeable about the topic in question. Primary or Direct Evidence supports a finding with the greatest degree of certainty. However. Such evidence does not require an inference or presumption on the part of the auditor in coming to a conclusion. However. Therefore. The value of testimonial evidence depends on the validity of the information source. Such evidence may be documented in the form of memoranda. is generally considered direct evidence of the terms of a contract. comparisons. Physical Evidence is gathered by the auditor through direct inspection or observation of people. Testing compliance with statutes. If possible. 1. 89 . Unsupported Allegations Auditors may occasionally receive unsupported allegations about personnel or programs under review. E. Inventory counts. and procedures. Unsupported allegations must be corroborated with additional evidence before a finding can be developed. Auditors must exercise judgment when using observation as an audit tool. Is the allegation related to the audit? Is the allegation serious? Is the source of the information reliable? Is the source of the information in a position to know what they are talking about? 3. Observations are subject to interpretation and may be refuted. c. The use of observation has some potential limitations for the following reasons: a. The following guidelines address this issue: 1. b. estimating transaction volumes. Documenting procedures and workflows b. Auditors must judge for themselves whether their evidence meets these criteria. and other condition measurements c. policies. d. 2. sufficient. administrative rules. Unsupported allegations are not evidence. Relevant Evidence is evidence that has a logical relationship to the issue. observations should be corroborated with other evidence. c. Adequacy of Audit Evidence Evidence must be relevant. b. Individuals may behave differently while under observation. Auditors should use judgment in deciding whether or not to follow-up on unsupported allegations by asking: a. and competent in order to adequately support an audit finding. D.89 a. The case or incident observed may be an aberration and not typical of standard practice. 90 2. Sufficient Evidence exists when there is enough factual and convincing information to support a finding. 3. Competent Evidence exists when the information is valid and reliable. The following general rules apply to competency: a. Evidence from an independent source is generally more competent than a nonindependent source. b. The stronger the auditees’ control systems, the more competent the evidence. c. Evidence obtained through physical examination, observation, computation, and inspection is more competent than evidence obtained indirectly (e.g., through interviews). d. Original documents are more competent than copies. V. REVIEW AND EVALUATION OF FINDINGS Audit supervisors are responsible for reviewing findings developed through the audit process. All findings included in audit reports must be supported by information contained in the workpapers. A. IIA Standards for Review and Evaluation of Findings Specific guidance for communicating results is given in IIA Standard 430.04.5 through 430.05. The following is the complete text of IIA Standard 430.04.5 through 430.05: 430.04.5 Results may include findings, conclusions (opinions), and recommendations. .6 Findings are pertinent statements of fact. Those findings which are necessary to support or prevent misunderstanding of the internal auditor’s conclusions and recommendations should be included in the final audit report. Less significant information or findings may be communicated orally or through informal correspondence. .7 Audit findings emerge by a process of comparing what should be with what is. Whether or not there is a difference, the internal auditor has a foundation on which to build the report. When conditions meet the criteria, acknowledgment in the audit report of satisfactory performance may be appropriate. Findings should be based on the following attributes: a. Criteria: The standards, measures, or expectations used in making an evaluation and/or verification (what should exist). Condition: The factual evidence which the internal auditor found in the course of the examination (what does exist). Cause: The reason for the difference between the expected and actual conditions (why the difference exists). b. c. 90 91 d. Effect: The risk or exposure the auditee organization and/or others encounter because the condition is not the same as the criteria (the impact of the difference). In determining the degree of risk or exposure, internal auditors should consider the effect their audit findings may have on the organization’s financial statements. Reported findings may also include recommendations, auditee accomplishments, and supportive information if not included elsewhere. e. .8 Conclusions (opinions) are the internal auditor’s evaluations of the effects of the findings on the activities reviewed. They usually put the findings in perspective based upon their overall implications. Audit conclusions, if included in the audit report, should be clearly identified as such. Conclusions may encompass the entire scope of an audit or specific aspects. They may cover, but are not limited to, whether operating or program objectives and goals conform with those of the organization, whether the organization’s objectives and goals are being met, and whether the activity under review is functioning as intended. .05 Reports may include recommendations for potential improvements and acknowledge satisfactory performance and corrective action. .1 Recommendations are based on the internal auditor’s findings and conclusions. They call for action to correct existing conditions or improve operations. Recommendations may suggest approaches to correcting or enhancing performance as a guide for management in achieving desired results. Recommendations may be general or specific. For example, under some circumstances, it may be desirable to recommend a general course of action and specific suggestions for implementation. In other circumstances, it may be appropriate only to suggest further investigation or study. .2 Auditee accomplishments, in terms of improvements since the last audit or the establishment of a well-controlled operation, may be included in the audit report. This information may be necessary to fairly represent the existing conditions and to provide a proper perspective and appropriate balance to the audit report. B. Additional Guidelines for the Review and Evaluation of Findings 1. There are five elements of a finding: a. Condition (what is happening now or what has happened in the past) b. Criteria (the standard of what should exist) c. Cause (why condition does not agree with criteria) d. Effect (so what?) e. Recommendations (suggestions to correct the existing condition and to prevent it from recurring) 2. All of the elements of a finding should be present when possible. If an element is missing, the supervisor must determine whether it is the result of deficient audit work or inadequate presentation. 91 92 3. Recommendations should address specific actions to correct the problem and should not merely reiterate the condition statements. 4. Audit criteria should be reasonable and relate to management objectives. 5. Effect statements should not be overstated or understated. VI. AUDIT REPORTS The audit report describes the results of the audit process. Reports should be prepared with due professional care because they represent the primary form of communication with management regarding the state of the organization’s control systems. A. IIA Standards for Audit Reports Specific guidance for communicating results is given in IIA Standard 430.01 through 430.04.4. The following is the complete text of IIA Standard 430.01 through 430.04.4: 430 Communicating Results Internal auditors should report the results of their audit work. .01 A signed, written report should be issued after the audit examination is completed. Interim reports may be written or oral and may be transmitted formally or informally. .1 Interim reports may be used to communicate information which requires immediate attention, to communicate a change in audit scope for the activity under review, or to keep management informed of audit progress when audits extend over a long period. The use of interim reports does not diminish or eliminate the need for a final report. .2 Summary reports highlighting audit results may be appropriate for levels of management above the auditee. They may be issued separately from or in conjunction with the final report. .3 The term signed means that the authorized internal auditor’s name should be manually signed in the report. Alternatively, the signature may appear on a cover letter. The internal auditor authorized to sign the report should be designated by the director of internal auditing. .4 If audit reports are distributed by electronic means, a signed version of the report should be kept on file in the internal auditing department. .02 Internal auditors should discuss conclusions and recommendations at appropriate levels of management before issuing final written reports. .1 Discussion of conclusions and recommendations is usually accomplished during the course of the audit and/or at post-audit meetings (exit interviews). Another technique is the review of draft audit reports by management of the auditee. These discussions and reviews help ensure that there have been no misunderstandings or misinterpretations of fact by providing the opportunity for the auditee to clarify specific items and to express views of the findings, conclusions, and recommendations. 92 93 .2 Although the level of participants in the discussions and reviews may vary by organization and by the nature of the report, they will generally include those individuals who are knowledgeable of detailed operations and those who can authorize the implementation of corrective action. .03 Reports should be objective, clear, concise, constructive, and timely. .1 Objective reports are factual, unbiased, and free from distortion. Findings, conclusions, and recommendations should be included without prejudice. a. If it is determined that a final audit report contains an error, the director of internal auditing should consider the need to issue an amended report which identifies the information being corrected. The amended audit report should be distributed to all individuals who received the audit report being corrected. b. An error is defined as an unintentional misstatement or omission of significant information in a final audit report. .2 Clear reports are easily understood and logical. Clarity can be improved by avoiding unnecessary technical language and providing sufficient supportive information. .3 Concise reports are to the point and avoid unnecessary detail. They express thoughts completely in the fewest possible words. .4 Constructive reports are those which, as a result of their content and tone, help the auditee and the organization and lead to improvements where needed. .5 Timely reports are those which are issued without undue delay and enable prompt effective action. .04 Reports should present the purpose, scope, and results of the audit; and, where appropriate, reports should contain an expression of the auditor’s opinion. .1 Although the format and content of the audit reports may vary by organization or type of audit, they should contain, at a minimum, the purpose, scope, and results of the audit. .2 Audit reports may include background information and summaries. Background information may identify the organizational units and activities reviewed and provide relevant explanatory information. They may also include the status of findings, conclusions, and recommendations from prior reports. There may also be an indication of whether the report covers a scheduled audit or the response to a request. Summaries, if included, should be balanced representations of the audit report content. .3 Purpose statements should describe the audit objectives and may, where necessary, inform the reader why the audit was conducted and what it was expected to achieve. .4 Scope statements should identify the audited activities and include, where appropriate, supportive information such as time period audited. Related activities not audited should be identified if necessary to delineate the boundaries of the audit. The nature and extent of auditing performed also should be described. B. Additional Guidelines for Audit Reports 1. Audit reports should be objective. 93 94 2. Audit reports must be factual. All questions of fact should be discussed and resolved with the auditee prior to issuing the report. 3. Findings must be adequately supported. Burden of proof for findings rests with the auditor, not the auditee. 4. The tone of the report should be constructive. Focus should be more on emphasizing needed improvements, rather than on criticizing past deficiencies. 5. Executive summaries are typically one-page attachments to the report that briefly describe what was audited, the auditor’s conclusions and significant findings, and action taken by the auditee on the findings. 6. The purpose of a written report is to communicate the results of the audit and to facilitate corrective action. 7. A description of the scope of the audit and the methodologies used helps readers understand the purpose of the audit and judge the quality of the work performed. 8. The scope and methodology section may include a description of criteria, sampling plans, and significant assumptions. 9. In some cases, it may be necessary to include a statement of objectives or issue areas that were not pursued during the audit. VII. PERMANENT FILES Permanent files contain information of continuing interest and relevance to a particular audit. Auditors assigned to a project should review information in the permanent file before beginning the audit. Also, the permanent file records should be updated on a regular basis. A. IIA Standards for Permanent Files Specific guidance for communicating results is given in IIA Standard 420.01.1.g. The following is the complete text of IIA Standard 420.01.1.g : 420.01.1 g. Some audit workpapers may be categorized as permanent or carry-forward audit files. These files generally contain information of continuing importance. B. Types of Information Typically Contained in Permanent Files 1. Background and history information 2. Organizational charts 94 95 3. Mission statements 4. Articles of incorporation 5. Bylaws 6. Charter 7. Outstanding bond indenture agreements 8. Contracts 9. Process flowcharts 10. Prior audits 11. Annual Reports 95 profit centers. Failure to accomplish established objectives and goals for operations or programs. and damage to the organization’s reputation. RISK ASSESSMENT Risk assessment is a way of identifying potential effects and their significance A. inappropriate accounting. e. The following is the complete text of IIA Standard 520. and an assessment of their relative significance. Erroneous record keeping. .2 The term risk is the probability that an event or action may adversely affect the organization. and practices.04.1-14. and procedures. financial loss and exposure. or not complying with relevant laws and regulations. An erroneous decision from using incorrect. IIA Standards for Risk Assessment Specific guidance for communicating results is given in IIA Standard 520. incomplete. 96 . g. Failure to adequately safeguard assets. and investment centers. Auditable activities may include: a.4 The first phase of the risk assessment process is to identify and catalog the auditable activities. f. . Policies. plans.04. c. d.1-14: 520. I. Acquiring resources uneconomically or using them inefficiently or ineffectively.3 The effects of risk can involve: a. procedures.5 Auditable activities consist of those subjects. b. identification of relevant risk factors. negative publicity. Cost centers. units. . . fraudulent financial reporting. or systems which are capable of being defined and evaluated. or otherwise unreliable information.04.96 UNIT 5: AUDIT TECHNIQUES Audit techniques encompasses the generally accepted methods for the performance of audits in accordance with audit standards. untimely.1 The risk assessment process includes identification of auditable activities. Failure to adhere to organizational policies. b. Customer dissatisfaction. adequacy. but sufficient to provide the director of internal auditing with confidence that the risk assessment is comprehensive. Competence. c. production. conditions and/or events may occur that could adversely affect the organization. treasury. liquidity. j. e. g. f. Management judgments and accounting estimates. i. n. h. General ledger account balances. Ethical climate and pressure on management to meet objectives. e. Date and results of previous audits.6 Risk factors are the criteria used to identify the relative significance of. b. Organizational. and capital assets. Impact of customers. g. purchasing. j. Laws and regulations. Financial and economic conditions. accounting. Organizational units such as product or service lines. purchasing. and human resources. Major contracts and programs. production. marketing. . Financial statements. Geographical dispersion of operations. Acceptance of audit findings and corrective action taken. f.8 Risk factors may include: a. d. and government regulations. or economic changes. finance. operational. d. and integrity of personnel. inventory and cost accounting. Functions such as information technology. . or transaction volume.7 The number of risk factors utilized should be limited. Transaction systems for activities such as sales.97 c. Asset size. h. k. collection. l. Adequacy and effectiveness of the system of internal control. i. technological. and likelihood that. Complexity or volatility of activities. . Degree of computerized information systems. payroll. Information systems (manual and computerized). disbursement. Competitive conditions. suppliers. m. 97 . The auditor is concerned with matters that could be material to the financial statements. and SAS 82 addresses the consideration of fraud in a financial statement audit. The risk assessment process should provide a means of organizing and integrating professional judgments for development of the audit work schedule. . but are not limited to: discussions with the board and various members of management.10 Risk assessment is a systematic process for assessing and integrating professional judgments about probable adverse conditions and/or events. 98 . AICPA Standards for Audit Risk SAS 47 (AU Section 312) and SAS 82 (AU Section 316) provides additional guidance when considering risk factors in an audit. consideration of applicable laws and regulations. Such an assessment will assist the director of internal auditing in making appropriate adjustments to audit priorities and the work schedule. These statements are discusses below. B. The weighing of risk factors reflects the director’s judgment about the relative impact a factor may have on selecting an activity for audit. Overview of SAS 47 “Audit Risk and Materiality in Conducting an Audit” 1. 3. The director may adjust the planned audit work schedule after considering other information such as coordination with external auditors and requests by management and the board. . because conditions change. and industry or economic trends. audit priorities determined through the risk assessment process may be reviewed and updated throughout the year. review of prior audits.9 The director of internal auditing may decide to weigh the risk factors to signify their relative significance. 2. analyses of financial and operating data.14 The risk assessment process should be conducted annually. .98 . However. C. The term errors refers to unintentional misstatements or omissions of amounts or disclosures in financial statements. . The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements. that are not material to the financial statements are detected. SAS 47 discusses audit risk and materiality in conducting an audit. .12 The risk assessment process should lead the director of internal auditing to establish audit work schedule priorities. Such sources include.13 There should be a periodic assessment of the effect of any major changes in the catalog of auditable activities or related risk factors which have occurred since the audit work schedule was prepared.11 The director should incorporate information from a variety of sources into the risk assessment process. discussions among management and staff of the internal auditing department. discussions with external auditors. whether caused by errors or fraud. The director of internal auditing should generally assign higher audit priorities to activities with higher risks. The primary factor that distinguishes fraud from error is whether the underlying action that results in the misstatement in financial statements is intentional or unintentional. Inherent risk is the susceptibility to material misstatement or material noncompliance assuming there are not related internal control structure policies or procedures. These pertain to management’s abilities. pressures. b. c. Types of Audit Risk 1. the entity’s financial condition. 3. 5. As part of the risk assessment.99 4. and attitude relating to internal control and the financial reporting process. 99 . the auditor should inquire of management (a) to obtain management’s understanding regarding the risk of fraud in the entity and (b) to determine whether they have knowledge of fraud that has been perpetuated on or within the entity. Risk factors that relate to misstatements arising from fraudulent financial reporting may be grouped in the following three categories: a. E. Industry conditions. and its profitability. These involve the economic and regulatory environment in which the entity operates. Overview of SAS 82 “Fraud in a Financial Statement Audit” 1. When fraud is detected. b. Management’s characteristics and influence over the control environment. Risk factors that relate to misstatements arising from misappropriation of assest may be grouped into two categories: a. 4. D. The auditor’s consideration of materiality is a matter of professional judgment and is influenced by his or her perception of the needs of a reasonable person who will rely on the financial statements. style. Operating characteristics and financial stability. the auditor should consider the implications for the integrity of management or employees and the possible effect on other aspects of the audit. These involve the lack of controls designed to prevent or detect misappropriations of assets. Susceptibility of assets to misappropriation. 2. Controls. These pertain to the nature of an entity’s assets and the degree to which they are subject to theft. These pertain to the nature and complexity of the entity and its transactions. The auditor should use professional judgment when assessing the significance and relevance of fraud risk factors and determining the appropriate audit responses. The risk factors identified. Specific risk analysis includes limited control testing to ascertain the extent to which a risk exists that the prescribed procedures and methods are not in use or are not operating as planned. and abuse. are procedures to determine the reasonableness of data. 3. The auditor’s response to the risk factors identified. 3. Preliminary risk analysis includes obtaining knowledge and understanding of the procedures and methods prescribed in the system and assessing the extent to which the prescribed procedures and methods are capable of satisfying the auditee’s control objectives. 2. 2. A.01. focusing on those control objectives and control techniques which are the most significant and have the greatest potential for fraud. Methodology for Evaluating Risk 1. IIA Standards for Analytical Reviews Specific guidance for analytical reviews is given in IIA Standard 420. often referred to as reasonableness tests. The document should include: 1. II. The following is the complete text of IIA Standard 420. ANALYTICAL REVIEWS Analytical reviews. Documentation of Risk Assessment The auditor should document in the workpapers evidence that the risk assessment was performed. Control risk is the risk that material misstatement or material noncompliance could occur and not be detected on a timely basis by the entity’s internal control structure policies and procedures. Substantive control testing includes the performance of detailed control tests.01: 420 Examining and Evaluating Information 100 . Analytical reviews can be used to determine the reasonableness of financial information or to assess operational results. Detection risk is the risk that audit procedures will not detect material misstatement or material noncompliance when it exists.100 2. waste. G. F. errors. recorded payroll expense compared to changes in average number of employees). ratios. and document information to support audit results.01 The process of examining and evaluating information is as follows: . in the absence of known conditions to the contrary. accounting. Examples of contrary conditions include unusual or nonrecurring transactions or events. relationships among information may reasonably be expected to exist and continue. f. e.101 Internal auditors should collect. irregularities. ineffectiveness. . — The absence of differences when they are expected. — Potential irregularities or illegal acts. g. Analytical auditing procedures may include: — Comparison of current period information with similar information for prior periods. The assessment results from comparing such information with expectations identified or developed by the internal auditor. environmental. — Study of relationships among elements of information (for example. or percentages. — Study of relationships of financial information with the appropriate nonfinancial information (for example. Analytical auditing procedures may be performed using monetary amounts. and technological changes. Analytical auditing procedures provide internal auditors with an efficient and effective means of making an assessment of information collected in an audit. — Comparison of current period information with budgets or forecasts. interpret. analyze. — Potential errors. or illegal acts. d.1 Information should be collected on all matters related to the audit objectives and scope of work. physical quantities. — Comparison of information with similar information for other organizational units. Analytical auditing procedures are performed by studying and comparing relationships among both financial and nonfinancial information. Analytical auditing procedures are useful in identifying. fluctuation in recorded interest expense compared to changes in related debt balances). — Other unusual or nonrecurring transactions or events. operational. 101 . c. The application of analytical auditing procedures is based on the premise that. — Comparison of information with similar information for the industry in which the organization operates. b. organizational. inefficiencies. among other things: — Differences that are not expected. Internal auditors use analytical auditing procedures when examining and evaluating information. a. as necessary. — The adequacy of the system of internal control. l. 102 . j. n. i. After evaluating the aforementioned factors. Specific analytical auditing procedures include. The examination and evaluation of unexpected results or relationships from applying analytical auditing procedures should include inquiries of management and the application of other auditing procedures until internal auditors are satisfied that the results or relationships are sufficiently explained. Analytical auditing procedures assist internal auditors in identifying conditions which may require subsequent auditing procedures. or illegal act. AICPA Standards for Analytical Procedures SAS 56 (AU Section 329) provides guidance regarding the use of analytical procedures. Internal auditors should use analytical auditing procedures in planning the audit in accordance with the guidelines contained in Section 410 of the Standards. The major points of SAS 56 are summarized as follows: 1. When analytical auditing procedures identify unexpected results or relationships. Results or relationships from applying analytical auditing procedures that are not sufficiently explained should be communicated to the appropriate levels of management. Analytical auditing procedures should also be used during the audit to examine and evaluate information to support audit results. period-to-period comparisons. Unexplained results or relationships from applying analytical auditing procedures may be indicative of a significant condition such as a potential error. but are not limited to. and regression analysis. and external economic information. internal auditors should consider and use additional auditing procedures. Internal auditors may recommend appropriate courses of action. irregularity. comparisons with budgets. internal auditors should examine and evaluate such results or relationships. m. Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. B. to achieve the audit objective. trend. reasonableness tests. Internal auditors should consider the following factors in determining the extent to which analytical auditing procedures should be used: — The significance of the area being examined. forecasts. — The availability and reliability of financial and nonfinancial information. — The precision with which the results of analytical auditing procedures can be predicted. ratio. k. — The extent to which other auditing procedures provide support for audit results. depending on the circumstances. — The availability and comparability of information regarding the industry in which the organization operates.102 h. business changes. b.103 2. b. to expectations developed by the auditor. 103 . To assist the auditor in planning the nature. random fluctuations. timing. Analytical procedures involve comparisons of recorded amounts. Anticipated results—for example. 4. c. As an overall review of the financial information in the final review state of the audit. Following are examples of sources of information for developing expectations: a. including extrapolations from interim or annual data. e. accounting changes. 6. Analytical procedures are used for the following purposes: a. and extent of other auditing procedures. As a substantive test to obtain evidential matter about particular assertions related to account balances or classes of transactions. d. The plausibility and predictability of the relationship. Particular conditions that can cause variations in these relationships include. The auditor develops such expectations by identifying and using plausible relationships that are reasonably expected to exist based on the auditor’s understanding of the client and of the industry in which the client operates. c. Analytical procedures range from simple comparisons to the use of complex models involving many relationships and elements of data. Relationships of financial information with relevant nonfinancial information. or ratios developed from recorded amounts. or misstatements. gross margin information. Information regarding the industry in which the client operates—for example. among other things: a. The nature of the assertion. 3. Relationships among elements of financial information within the period. 5. The expected effectiveness and efficiency of an analytical procedure in identifying potential misstatements depends on. budgets or forecasts. b. specific unusual transactions or events. for example. A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. Financial information for comparable prior period(s) giving consideration to known changes. 7. d. It is important for the auditor to understand the reasons that make relationships plausible because data sometimes appear to be related when they are not. b. 104 . Whether the expectations were developed using data from a variety of sources. Often less costly and less time consuming than other substantive tests. D. Whether the data was obtained from independent sources outside the entity or from sources within the entity. which could lead the auditor to erroneous conclusions. Whether sources within the entity were independent of those individuals responsible for the amount being audited. Types of Analytical Reviews 1. Whether the data was developed under a reliable system of controls. Directs attention to potential problem areas. Aids in the selection of entities to audit. c. The availability and reliability of the data used to develop the expectation. The precision of the expectation. Provides information for analyzing risk. 5. 4. Benefits of Analytical Reviews 1. Whether the data was subjected to audit testing in the current or prior year. 3. C. The following factors influence the auditor’s consideration of the reliability of data for purposes of achieving audit objectives: a. Trend analysis is used to compare current account balances with the account balances for the prior year(s). The reliability of the data used to develop the expectations should be appropriate for the desired level of assurance from the analytical procedures.104 c. 9. e. 8. 2. Useful in planning audits and defining scope. d. the auditor’s conclusions may be different from the conclusions that would be reached if the test were applied in the same way to all items in the account balance or class of transactions. There are two general approaches to audit sampling: non-statistical and statistical. AICPA Standards for Audit Sampling SAS 39 (AU Sections 350) provides guidance regarding the use of audit sampling. 105 . d. b. Ratio analysis is used to compare current ratios with ratios for the prior year(s) or with an industry average. This section generally focuses on techniques and approaches for performing a statistical sample. Regression analysis is used to show relationships between two or more variables. A. sampling is necessary. when a test of controls or a substantive test is restricted to a sample. The major points of these Statements that are relevant to this section are as follows: 1. The proper use of statistical sampling helps ensure the accuracy and reliability of the sample results. In these cases. Sampling risk arises from the possibility that. 2.105 2. The auditor is concerned with four aspects of sampling risk: a. The risk of assessing control risk too low is the risk that the assessed level of control risk based on the sample is less than the true operating effectiveness of the control. c. Audit sampling is the application of an audit procedure to less than 100 percent of the items within an account balance or class of transactions for the purpose of evaluating some characteristic of the balance or class. STATISTICAL SAMPLING The cost associated with a complete review of all records or transactions is often prohibitive. 3. The risk of incorrect rejection is the risk that the sample supports the conclusion that the recorded account balance is materially misstated when it is not materially misstated. The risk of assessing control risk too high is the risk that the assessed level of control risk based on the sample is greater than the true operating effectiveness of the control. The risk of incorrect acceptance is the risk that the sample supports the conclusion that the recorded account balance is not materially misstated when it is materially misstated. III. Statistical sampling helps the auditor: a. By using statistical sampling techniques. 4. in an account balance or class of transactions should be individually examined and which items. 8. 6. Auditors should examine those items for which. b.. Therefore. The auditor’s allowable risk of assessing control risk too low. When planning a particular audit sample for a test of controls. Non-sampling risk includes all the aspects of audit risk that are not due to sampling. 106 . all items in the population should have an opportunity to be selected. the items comprising the account balance or class of transactions of interest). 9. When planning a sample for a substantive test of details. To measure the sufficiency of the evidential matter obtained. the auditor uses judgment to determine which items. Basic Steps For Developing a Statistical Sample 1.e. b. The maximum rate of deviations from prescribed controls that would support the assessed level of control risk. 2. in their judgment. 7. Define the population (e. Characteristics of the population (i. the auditor should consider: a. the auditor can quantify sampling risk to assist in limiting it to an acceptable level. acceptance of some sampling risk is not justified. Determine the objectives of the test. The relationship of the sample to the objective of the test of controls. if any. d. c. if any. Sample items should be selected in such a way that the sample can be expected to represent the population. number of transactions during the audit period). To design an efficient sample.106 3. To evaluate the sample results. c.. The auditor may be able to reduce the required sample size by separating items subject to sampling into relatively homogeneous groups on the basis of some characteristic related to the specific audit objective. should be subject to sampling. B. 5.g. 2. Determine the sample size. which involves taking a random start and then every nth item. Population variability. D. 5. A sample is then selected from one or more subgroups as necessary to meet audit objectives. If appropriate.g. 9. Review the items selected. b. Stratifying a sample involves assigning similar items into subgroups. which involves using a random number generator to select items to be tested. such as: a. This can be done by using printed or electronic tables or formulas. Variables Affecting Sample Size 1. Select a sampling methodology. 6. 3.107 3. Assess sampling risk and determine an acceptable level (e. c. 5% or 10%). 4. Larger variability in the population (measured by the standard deviation for variables sampling or the expected deviation rate for attribute sampling) requires a larger sample. 7. larger populations require a larger sample. Acceptable level of misstatement or deviation. Population size. 8. Smaller amounts of acceptable risk require larger samples.. Random sampling. C. Variables Sampling 107 . Acceptable level of risk. which involves randomly selecting groups of items to sample. The smaller the acceptable misstatement amount (in variables sampling) or the smaller acceptable deviation rate (in attribute sampling). 4. Cluster or block sampling. Document the results of the tests. stratify the sample. Systematic sampling. Generally. the larger the required sample. Take the sample. narratives. Difference estimation. 2. Each method is described below. 1.108 A variables sampling plan is most commonly used to test whether recorded account balances are fairly stated. Common types of variables sampling are described below: 1. The auditor estimates the population misstatement by multiplying the recorded value of the population by the ratio of the total audit value of the sample items to their total recorded value. the auditor tries find at least one deviation in the sample. Common types of attributes sampling are described below. Attributes Sampling Attribute sampling concerns binary (e. A. 2. The difference is then added (if there is a net understatement) or subtracted (if there is an net overstatement) to yield an estimated audited value. Sequential (stop or go) sampling. Discovery sampling. NARRATIVES. Flowcharting Symbols 108 . When the expected rate of deviation is very low (near zero). Interrelated symbols are used to diagram the flow of events or data through a system. divides the net sample difference by the sample size. yes/no) propositions. The auditor performs the sampling plan in stages. The auditor uses variables sampling to reach conclusions about a population in terms of a dollar amount. The auditor determines differences between the recorded and audited values for items in the sample. and then multiplies the result by the population size. the auditor decides whether or not to go to the next stage. E. Flowcharts can provide a good initial overview of an entire system.. IV. Attributes sampling is commonly used to test the rate of deviation (or rate of occurrence) in a population. The auditor estimates the average audited value for each population item from the average in the sample and then calculates the estimated audited value for the account by multiplying the average audited value and the population size. Flowcharting A flowchart is a visual representation of how a process works. Ratio estimation. Mean-per-unit estimation. FLOWCHARTING. Following each stage. AND QUESTIONNAIRES The three primary methods auditors use to document an entity’s internal controls are flowcharts. The auditor may decide to use one or more of these methods to document a system.g. 3. and questionnaires. Connector and Predefined Process. This is not a complete list of all the possible flowcharting symbols. True/False) 109 .109 There are 6 basic symbols commonly used in flowcharting of assembly language programs: Terminal. Process. it is a list of commonly used symbols. Symbol Name Function Process Indicates any type of internal operation inside the Processor or Memory Input/Output Used for any Input / Output operation Outside the Processor. Decision. Input/Output. Decision Used to ask a question that can be answered in a binary format (Yes/No. Flowchart symbols have an entry point on the top of the symbol with no other entry points. 8. • An upward flow of more then 3 symbols 6. The exit point for all flowchart symbols is on the bottom except for the Decision symbol. Terminal Indicates the starting or ending of the program. 3. or interrupt program. without intersecting lines or a reverse flow. Predefined Process Used to invoke a subroutine or an interrupt program. 7. Examples are: • From one page to another page. an upward flow can be shown as long as it does not exceed 3 symbols. bottom frame points to the destination page. on the same page. (Not lines) 2. 4. these can be on the sides or the bottom and one side. All boxes of the flowchart are connected with Arrows. General Rules for flowcharting 1. • From the bottom of the page to the top of the same page. 5. Upper frame reserved for the sending page. process. All flowcharts end with a terminal or a continuous loop. Generally a flowchart will flow from top to bottom. However. The Decision symbol has two exit points. On-page Connector Allows for the continuos flow of logic to be described. Connectors are used to connect breaks in the flowchart. 110 . Subroutines and Interrupt programs have their own and independent flowcharts. All flow charts start with a Terminal or Predefined Process (for interrupt programs or subroutines) symbol. while preserving a link back to an original point of reference.110 Off-page Connector Allows the flowchart to be carried forward to subsequent pages. Obtaining the response from the third party. CONFIRMATIONS A confirmation is a letter or affidavit from an independent third party that confirms the existence and valuation of some account balance. Evaluating the information. Designing the confirmation request. The key points of this Statement are: 1. Any potential deficiencies or weaknesses noted in the questionnaires indicate areas that should be focused on during fieldwork testing. AICPA Standards on Confirmations SAS 67 (AU Section 330) provides guidance on the use of confirmations. c. including the reliability of that information.111 B. b. d. A. Questionnaires An internal control questionnaire is designed to indicate control deficiencies. confirmations are particularly useful in instances when inherent and control risk are determined to be high. lengthy written description of a system is often difficult to understand. 111 . Narratives A narrative is a written description of a phase or a particular phase of a system. e. The internal control questionnaire for a particular audit area is typically filled-out at the beginning of the audit. When obtaining evidence for assertions not adequately addressed by confirmations. provided by the third party about the audit objectives. simply because a complex. A written narrative is most useful when describing relatively simple systems. or lack thereof. Selecting items for which confirmations are to be requested. 3. C. 2. V. Communicating the confirmation request to the appropriate third party. auditors should consider other audit procedures to complement confirmation procedures or to be used instead of confirmation procedures. Because confirmations provide evidence. The confirmation process includes: a. 10. including the implications. but request the recipient to fill in the balance or furnish other information. A large number of small balances in involved. Negative forms request recipients to respond only if they disagree with the information stated on the request. b. The auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration. performing the confirmation procedures. such as verifying the source and content of the facsimile in a telephone call to the purported sender. b. both quantitative and qualitative. the auditor should consider taking certain precautions. and evaluating the results of the confirmation procedures. 6. c. referred to as blank forms. 5. The combined assessed level of inherent risk and control risk is low.112 4. 9. but they often result in a lower response rate. Other positive forms. the auditor should generally follow up with a second and sometimes a third request to those parties from whom replies have not been received. nonresponses do not provide audit evidence about the financial statement assertions being addressed. do not state the amount (or other information) on the confirmation request. the auditor should consider asking the purported sender to mail the original confirmation directly to the auditor. The evidence provided by other procedures. Blank forms generally produce a higher degree of assurance. Positive forms provide audit evidence only when responses are received from the recipients. The nature of any exceptions. 112 . of those exceptions. There are two types of confirmation requests: positive confirmations (the positive form) and negative confirmations (the negative form). 7. When using confirmation requests other than the negative form. Whether additional evidence is needed. The auditor should exercise an appropriate level of professional skepticism when designing the confirmation request. 8. d. To restrict the risks associated with facsimile responses. In addition. Some positive forms request respondents to indicate whether they agree with the information stated on the request. When evaluating the results of confirmation procedures. the auditor should consider: a. Negative confirmation requests may be used to reduce audit risk to an acceptable level when: a. The reliability of the confirmations and alternative procedures. c. The auditor is to determine whether any instances of noncompliance may have a material effect on the financial statements. Confirm cash balances at banks and other depositories. B. Confirm loans and notes payable directly with creditors. Confirm securities and other negotiable instruments held by independent custodians. Detection risk is the risk that the auditor’s procedures will not detect an error. Confirm bonds directly with trustees. 113 . Substantive Testing Substantive tests provide evidence about monetary misstatements. Confirm off-premises inventory. Some key points regarding substantive testing include: 1.113 11. 2. VI. regulations. 5. 6. Common Ways Auditors Use Confirmations 1. COMPLIANCE AND SUBSTANTIVE TESTING A. it is presumed that the auditor will request the confirmation of accounts receivable during an audit unless one of the following is true: a. policies. Compliance Testing Compliance testing is designed to determine whether an entity has complied with applicable laws. Auditors can determine the existence and valuation of an account by asking the customer in writing whether a recorded receivable is in the entity’s account payable. The audit risk is acceptably low. c. The extent of substantive testing depends on the acceptable level of detection risk. It is generally presumed that evidence obtained from third parties will provide the auditor with higher-quality audit evidence than is typically available from within the entity. B. The purpose of substantive testing is to hold detection risk to an acceptable level. and procedures. Thus. Confirm receivables balances. 4. 3. The use of confirmations would be ineffective. b. Accounts receivable are immaterial to the financial statements. Specific substantive tests include: a.. b. and notes payable examining bond indentures and other long-term indebtedness agreements verifying shareholders’ equity balances 114 . j. k. h. o. are accurate and complete. reviewing insurance policies to confirm coverage) verifying payroll preparation and distribution counting physical inventory verifying the accuracy of recorded fixed assets confirming or physically inspecting securities confirming bonds.114 2. c. e. n. verifying that purchases and payables were recorded in the appropriate period) determining whether unrecorded liabilities exist verifying prepaid expenses (e. i.g. and cash balances are to determine that the account balances exist. f.g.. d. m. loans. g. The objectives of substantive tests of sales. receivables. 3. verifying the mathematical accuracy of accounts confirming receivables balances determining whether receivables are collectable confirming cash balances confirming payables testing cutoff (e. l. and are properly presented and disclosed. 115 UNIT 6: INFORMATION SYSTEMS AUDITING I. Control which includes policies. facilities. information and the technology that supports it represent the organization's most valuable assets. Information Systems Auditing In today’s environment most information is produced through the use of computer systems. management must establish an adequate system of internal control. COBIT has a set of 32 high-level Control Objectives. The use of information systems permeates all aspects of an organization from electronic mail to the generation of annual reports. For many organizations. and monitoring. fiduciary reporting and security. one for each of the IT Processes. acquisition & implementation. there were limited audit standards for information systems auditors. practices and procedures is management's responsibility. delivery & support. as for all assets. grouped into four domains: planning & organization. Until recently. Such a system or framework must support the business processes and must be clear on how each individual control activity impacts the resources and satisfies the requirements. efficiency. organizational structures. Organizations must satisfy for their information. To discharge this responsibility. the requirements for quality. availability. information systems controls have become a critical control point. the Framework gives definitions for the business requirements that are distilled from higher level objectives for 115 . As a result. IT Resources need to be managed by a set of naturally grouped IT processes to provide the information that the enterprise needs to achieve its objectives. A Control Objective is a statement of the desired result or purpose to be achieved by implementing specific control procedures within an IT activity. integrity. compliance and reliability that need to be satisfied. Impact on IT resources is highlighted in the CobiT Framework together with the business requirements for effectiveness. Additionally. confidentiality. Below are some excerpts from the COBIT Executive Summary v It is management's responsibility to safeguard all the assets of the enterprise. The Information Systems Audit and Control Association developed Control Objectives for Information and related Technology (COBIT) in 1996 to provide auditors with information systems guidelines. Management must balance the use of available resources including people. application systems and data. as well as to achieve its expectations. technology. but the specific edit checks built into an application are unique to that application. Some specific general and application control areas are: A. For example. security and fiduciary reporting as they relate to Information Technology. General controls are those that apply to all computer activities. As a result. and obtain endorsement from the commercial. 116 . There are two broad categories of information system controls. the controls to protect information continue to lag behind. E. information processing have become a very valuable asset for many organizations. However. Internal Control Development Input/Processing/Output Controls Segregation of Duties Separation of Processing and Development Reconciliation of Input to Output Control of Data Files Authorization of Transactions Physical and Data Security Access Control End-User Computing – Including Microcomputers Business Risk Planning Audit Tools 1) Computer Assisted Audit Techniques 2) Automated Administrative Processes A. within the defined framework. it has been more difficult for many organizations to understand the value of information and. information and by association. Application controls apply to a specific application and are unique to that particular application. internal controls must be developed to safeguard the asset. governmental and professional world-at-large.116 quality. to effectively control it. the physical security controls would be the same for all applications. The main objective of the CobiT project is to enable the development of clear policy and good practice for IT control throughout industry. F. The management of the enterprise needs a framework of generally applicable and accepted IT security and control practices to benchmark their existing and planned IT environment. They generally apply to the entire computer operation and include physical and logical security controls that apply organization wide. since information is not a tangible asset. Note: COBIT is included in the recommended reading materials. general and application controls. G. information systems controls are gaining importance in progressive organizations. K. I. As indicated by the development of COBIT and the internal controls that will be discussed in this unit. Internal Control Development As outlined in the Executive Summary of COBIT. B. An effective security program emphasizes both general and application controls. Although organizations are beginning to understand the value of information. subsequently. C. J. D. It is CobiT's goal to provide these control objectives. worldwide. H. There are three specific categories of application controls: • Input controls help ensure that data received for processing have been properly authorized and converted. Some people advocate that librarians have limited access to equipment and have little or no programming skills. Segregation of duties is a basic control principle that prohibits the performance of duties that may permit someone to commit and conceal inappropriate activities. They also ensure that all transactions are processed as authorized. • • C. an that no unauthorized transactions were added. • D. Segregation of Duties Segregation of duties is a general control area and is critical in the information systems arena. no authorized transactions are omitted. For example. Separation of Processing and Development 117 . Input/Processing/Output Controls Input/processing/output controls are associated with a specific application and are referred to as application controls. Librarians should be prohibited from performing any operations or programming functions. Output controls help ensure that reports (hard copy or online) or other output such as warrants or invoices are accurate and are received or available to only authorized staff. • Computer operators are responsible for the actual processing of data and operate the equipment and respond to messages to permit final processing. Input controls also relate to the rejection.117 B. Librarians are the keeper of documentation. and is complete and accurate. Programmed edits such as the verification of employment status and salary limits are considered application controls. and data. it would be a significant control weakness for one person to perform data entry functions and receive and review the output. Processing controls help ensure that the processing has been performed as intended. programs. An example of an application is a payroll system which would automatically calculate pay rates and generate warrants. Computer operators should not have any programming duties and should be prohibited from accessing documentation not required to perform their job function. and resubmission of data that was originally incorrect. correction. Application controls relate to specific tasks performed by a computer system. Some examples of information system duties that should be segregated are listed below. Basically little or no reliance was placed on the integrity of the computer system and the audit techniques were similar to those used in the precomputer period. Each authorized user is provided with an ID that provides access to programs and data files based on job requirements. F. A programmer who has access to processing functions will have the capability to bypass controls to make and conceal unauthorized changes.118 The most important areas to segregate are the processing and development functions. For example. However. in a computerized environment. The primary logical security control in use today is the use of an ID and password. Accountants and internal auditors routinely perform reconciliation procedures in manual environment. This makes manual reconciliation of input to output virtually impossible. This approach required the auditor to perform a manual reconciliation of computer output to the source documents.and cost-prohibitive to perform a manual reconciliation. In addition. but the operator should deny access unless an approved request is on file. Reconciliation of Input to Output In a manual system. The lack of effective controls over the programming function can permit unauthorized changes to made with minimal chance of detection. The opposite is also true: programmers should be prohibited from entering the computer room where the consoles reside.” Auditing around the computer has been the standard in the audit community. operators often respond to requests on the console to permit programmer access to restricted libraries. The increased reliance on computer output without verification increases the need for additional controls. a payroll clerk for the administration division may have an ID . computer operators (processing function) must be clearly segregated from programming activities. The password is a secret code known only by the user and changed periodically ensure its confidentiality. The auditor only needs to perform limited reconciliation of input to output to provide an acceptable comfort level with the integrity of the output. As discussed above.PAY22 .which provides read and update to access to administration employees payroll records but prohibits access to all other payroll records and accounting data. For example. the source document (processed check or check register information) may not exist. For example. Auditing through the computer is becoming the accepted practice in the audit community. many of us manually reconcile our check register to our checking account statement on a monthly basis. or manipulation of data files and programs. The user PAY22 is required to have a password that is at least six characters in length and requires the use of a number in at least two of the six characters. the number of transactions in some systems makes it time. As auditors adapt to the computerized environment. they are “auditing through the computer” rather than “auditing around the computer. This approach requires the auditor to review the general and application controls that affect a computer system and verify the integrity and accuracy of the computer system. E. In addition. 118 . programmers must be prohibited from accessing or invoking any processing commands. use. reconciliation of input to output is a normal and routine process. Control of Data Files Control of data files or access controls is the use of techniques to prevent improper access. where people who perform the same function have the same access capability. or hand geometry to distinguish users. Additionally. There is also some resistance in the user community due to the perception that biometric devices are personally intrusive. where an authorized user is denied access.no access to the system or transactions • Group 2 . This simplifies the administration of security. However.general user . a user would place his or her index finger in a reader and this information would be compared to the stored information to permit or deny access.read only access to the system 119 . For example. read access (data can be read but not modified) may be acceptable for all users. See the example below: Payroll system • Group 1 . however. thereby permitting an unauthorized access. In either case. Any user with the proper key can decrypt the information into readable text. however. there are several issues associated with it use. access is permitted or denied at a transaction rather than data file level. in some instances update access to data may be permitted for all authorized users.payroll administrators . This can be due to changes in the individual or a faulty reading by the device. Two examples of these include: • Encryption uses an algorithm to manipulate plain text and render it unreadable. For example. • G. particularly sensitive transactions may be limited to 1% of the users. A bigger issue is a false-negative reading. voice patterns. retina patterns. but only 10% of the users need to perform selected transactions. The same techniques are used. There is the possibility of a false-positive reading. there is a high level of frustration for a denied user. Extending the sample above. This approach works well when transferring confidential or proprietary information over an unsecured network. as more critical and confidential information is placed on computers. Authorization of Transactions Authorization of transactions is actually a subset of the information outlined in the previous section. additional security measures have been developed. with no distinction between users. Under this approach. Biometrics uses something unique about an individual such as fingerprints. in most cases an additional level of security is required and that is where transaction level security comes into play. Encryption can also be an effective control when storing confidential or proprietary information on computers. An effective way to employ transaction security is to place users in common groups. Although biometrics provides excellent security. users will have their fingerprint or other characteristics scanned into the security system and access will be permitted only after comparing the scanned information to the current information. This situation is relatively rare and biometrics provide much greater security than passwords.119 The use of passwords has been an effective security tool. data must be backed up and stored off-site for a disaster contingency plan to be effective. Group 4 .update transaction permitted for all fields. support. Prior to microcomputers and networks (local and international (Internet)).payroll clerks . physical boundaries no longer exist. Disaster contingency planning information processing is the lifeblood of many organizations. Physical and Data Security Access Control Physical security is the security over access to the building and sensitive areas. We are all aware of the physical security controls associated with banks. major credit card companies have detailed an extensive contingency plans that permit a seamless transfer of processing capability from an inoperable site to an alternate site. In today’s environment. Card-key systems prevent or allow access to the main facility and can also further restrict access to sensitive areas within the facility. and security was controlled by data center staff. Fire prevention and detection since the information stored within a facility is extremely valuable. application development.master payroll clerks . In many cases guards and/or card-key systems are used to prevent unauthorized access. its importance has diminished with the widespread connectivity provided by networks. alternate processing plans must be developed and tested. Most computer facilities have detailed physical security controls and they generally include: • Access security most facilities restrict physical access to authorized personnel. no access to update transactions for any monetary fields. This approach will work with password and biometric based security systems. so logical security controls such as those in the two previous sections provide the primary security control.120 • • Group 3 . mainframe computer. For example. H. maintenance. Under this approach. I.update transaction permitted for select fields. Most other organizations have less extensive plans and have a backup site available that will permit them to continue operations in a 24-hour period. This centralized process promoted the establishment of accepted and consistent development and security standards. physical access to a specific terminal was often required to perform sensitive transactions. As the need for additional computer resources increased. and attached terminals. as a result. extensive fire prevention and detection are employed. Everything from purchase. users were often 120 . In any event. End-User Computing – Including Microcomputers End-user computing is the phenomenon that occurred after the introduction and acceptance of microcomputers. individuals are placed in groups and permitted or denied access based on the security parameters in the group. The historic computing environment consisted of a data center (computer facility). • • Although physical security is still very important. security was an after-thought and confidential and proprietary data was not always controlled properly. Some end-user computing issues include: • Technical expertise most end-users do not have a programming or computer science background and lack some of the basic knowledge to develop effective long term solutions. The basic business risks are routinely reviewed by senior management. Backup and contingency planning issues although end-users relied on their systems to meet their objectives. Microcomputers and local area networks provided users with the ability to satisfy their computing needs by procuring or developing their own systems. separate divisions often purchased incompatible hardware and software that prevented the transfer or sharing of data within the organization. unauthorized access. thus. However. The basic risks involve financing. basic control concepts such as backing-up data and storing it offsite were not adhered to. system calculations were wrong. In many cases. As this approach grew in popularity it was dubbed end-user computing. J. Some of these risks include: 121 . some of the basic control concepts from the centralized environment were not transferred to the end-user computing environment. In addition. it significantly increased the risk of data loss. and incorrect processing results. however. marketing. investment. In addition to the basic risks there are many other internal and external risks that impact businesses. • • • • End-user computing brought power to the users. Accepted control concepts such as developing adequate documentation of the system and programming were not adhered to. supply. in some cases. adequate testing to determine that the system processed correctly were not conducted. Development issues end-users often developed systems without using accepted development techniques. Compatibility issues end-users were interested in meeting their individual needs and did not look at systems from an organizational perspective. It provided users with the ability to develop or procure systems that met their unique needs. For example. end-users decided what level of security was appropriate.121 unable to have their computer needs satisfied by central data center staff. This made it difficult to modify the application. Security issues since security was not centrally controlled. Business Risk Planning There are inherent risks associated with any business. End-user computing proliferated in the late 1980s and early 1990s. and production. • • • As outlined in previous sections. External risks are risks associated with dealings with external parties. K. These include changes to tax law. This approach assumes that the processing is accurate if the inputs and outputs are correct. employees. auditors needed to develop new audit techniques and tools. Although an individual business may not be able to control these risk areas. Although unpredictable. Under this approach.122 • Information systems risks are risks that occur from the electronic transfer and storage of key business information. test data is run through the system to check for processing accuracy.under this approach. These include dealings with creditors. As more and more primary business functions were computerized auditors wanted additional assurances on the integrity of processing logic. not the processing. in a payroll system a fictitious employee 122 . businesses that did not adequately prepare for disasters have been unable recover the effects of disaster and been forces out of business. For example. Some specific methods or tools for auditing include: • Integrated Test Facility (ITF) . customers. they must analyze these risk areas and take action as appropriate. Computer systems. some companies that rely on computer systems to perform their primary business functions (such as credit card companies) have redundant computer and telecommunications systems that permit a seamless transition in case of a failure in one of the systems. audit tools were developed to permit auditors to efficiently audit through the computer. the enforcement of edit checks. Auditors had a choice to either audit “around the computer” or “through the computer. safety or environmental regulations. a fictitious entity is created and processed along with live data. Similar to natural disasters. fires. preparations must be made to reduce the impact of computer failures on operations. risks must be continually analyzed and addressed. Time and again. For example. and regulators. the program logic and edit checks are reviewed and verified. In some instances. competitors. Disaster risks are risks that occur from natural disaster such as earthquakes. and new statutory limitations. computer failures can significantly disrupt business operations. Legislative risks are risks associated with changes with law and policy that impact a business. or hurricanes. and output accuracy. preparations to reduce the potential negative consequences from a disasters must be made. investors. Information systems risks will continue to be a major concern as more organizations rely on these systems to perform primary business functions. shareholders.” Initially auditors audited around the computer and focused their efforts on the input and output from the system. Audit Tools As computers became integral to the performance of primary business functions. As a result. SCARF information is collected using the live data and system. However. For example. Like the ITF approach.software that assists the auditor in analyzing data and selecting samples. the historical internal controls were no longer valid or effective. Although sampling provides effective audit results. Computer Assisted Audit Techniques (CAATs) has become a common term in the information systems audit profession. Auditors frequently review global security standards such as password length and change interval.software that assists the auditor by performing online analysis of security software and operating system parameters. and the same is true for auditors. software can be used to find financial variances (such as a limit in the $ amount of a transaction) by identifying all transactions that exceeded the threshold. auditors would review the global system parameters and a sample of users and try to identify those that had less restrictive parameters. new internal control systems (as discussed previously) are required to effectively protect assets in the information age. As a result. Some general CAATs include: • Data Analysis Software . The predetermined results would be compared to the actual results. Security review software provides auditors with the capability to identify any user that has less restrictive parameters. data analysis software provides auditors with the capability to test all transactions.123 would be created and processed along with the normal payroll processing. • Systems Control Audit Review File (SCARF) . Historically. an embedded audit module collects data for subsequent review and analysis. L. Automated Administrative Processes Routine administrative processes such as payroll had a detailed internal control structure to prevent inappropriate transactions and access. Historically auditors selected a sample (often a judgmental sample or a random sample) and tested the sample transactions to verify the integrity of the internal controls. Security Review Software . Computerization provides core business units with increased ability to perform effectively. all users with a password of less than 6 characters could be identified. 123 . The audit community learned the value of computerization to enhance the quality and timeliness of audits. as more and more of these administrative processes became computerized. For example. computer assisted techniques will continue to evolve into routine audit techniques.under this approach. • As indicated above. Annual audit plan. Which of the following is an Audit Committee most likely to review and approve? A. 5. B. D. Which of the following objectives would be most likely to be classified as operational auditing? A. Approving changes to employee records and processing general ledger transactions D. According the CFSA Code of Professional Ethics. D. Collecting payments on accounts and reconciling accounts receivable records. impartiality and fairness. Identifying opportunities for improvement in performance of key functions. is obligated to report illegal or fraudulent activities to the appropriate authorities. B. strives to provide a value-added service to the organization. Evaluating the adequacy and effectiveness of the system of internal control. Audit director's salary. personnel management and development.124 STUDY QUESTIONS FOR VOLUME 1: AUDITING 1. Examining the means of safeguarding assets. D. B. C. 4. Audit department's annual budget. B. organizational status and objectivity. 2. B. will use the CFSA designation with pride and professionalism. is responsible for providing a professional evaluation of the system of internal control. independence in the internal auditor is achieved through A. C. Reviewing the reliability and integrity of financial and operating information. a CFSA A. Annual financial statements. C. 3.Which of the following would be most likely to be considered inadequate segregation of duties? A. Preparing customer statements and collecting payments on accounts. Maintaining custody of signed checks prior to mailing and preparing expense account subsidiary ledgers. C. 124 . C. management directive. According to the Standards for the Professional Practice of Internal Auditing. D. and interactive data input telecommunication controls. 7. evaluate the organization's compliance with regulatory requirements. C. The primary purpose of an internal audit is to A. C. Compliance tests to review the system of internal control. B. direct. III. II. 8. segregation of duties. Failure to detect or prevent file version errors and update or posting errors are caused by inadequate input controls. Which of the following best describes analytical review procedures? A. A. complementary. and III only II. and IV only I. II. Which of the following are control considerations for batch systems? A. appraise the organization's internal control system. Substantive tests to evaluate the reasonableness of financial information. C. Segregation of duties.125 6. Processing controls are intended to detect or prevent program bugs such as mathematical errors and decision tree errors. interim input reconciliations. or merged with other data. Which of the following are true concerning data files? I. B. D. The relationship between substantive tests and internal control is A. D. C. II. interim input reconciliations. 9. Program change control. parallel. Input controls include flagging duplicate transactions and validating special fields. III. modified. 10. evaluate the organization's financial accounting system and those activities having a material effect on the financial statements. Program change control. Compliance tests to evaluate the reasonableness of financial information. B. C. and interim input reconciliations. I and IV only I. inverse. and IV 125 . D. and interactive transaction authorization. attest to the accuracy of the organization's financial statements. D. Substantive tests to review the system of internal control. and interactive transaction authorization. IV. One objective of output controls is to ensure the integrity of stored data until it is deleted. B. segregation of duties. Program change control. III. D. B. 126 VOLUME II BANKING 126 . and other services/operations such as wire transfers. UNIT 1: FINANCIAL STATEMENT APPLICATIONS This unit covers the common financial statement applications in the banking industry. receivables. liabilities. credit card companies. assets are future economic benefits controlled by an entity. trust companies. shareholders’ equity. Unit 1 discusses financial statement applications. The guide is divided into two units. Assets may be tangible or intangible. In other words. credit unions. Due from bank balances are used to ensure liquid reserves. leasing companies. I. savings banks. and trusts. and mortgage bankers. property and equipment. 127 . A. and intangible assets. “Due from” bank balances are bank assets on deposit in other banks. finance companies. to facilitate the transfer of funds. Cash and Due From Banks 1. Noncurrent assets include long-term investments.127 CORE COMPETENCY NUMBER TWO: BANKING INDUSTRY This study guide covers a wide range of issues relating to commercial banks. this unit highlights other important money and banking issues. Unit 2 describes laws and regulations affecting the banking industry. Current assets typically include those assets an entity expects to convert into cash or be sold within one year. Something has asset value if it can contribute directly or indirectly to an entity’s cash flow. This section describes various categories of assets and their relationship to the financial statements. branch operations. The unit addresses issues related to assets. In addition. ASSETS Assets are one major element of the financial statements. and short-term investments. and to use as compensation for correspondent banking services. Current assets include cash. Federal funds transactions do not involve an actual transfer of funds. Checks are sent to the due from bank. B. Sales are good for one day only. Federal Funds Sold and Securities Purchased Under Resale 1. There are four categories of cash and cash due from banks: • Cash items are other items easily liquidated such as maturing coupons. Federal funds transactions may take the form of an unsecured loan where a bank sells funds one day and is repaid the next business day. Cash and due from other bank accounts that are listed as a caption on the balance sheet should include all currency and coin. and unposted debits. The federal funds are returned to the selling bank on the following business day. On a specified date (usually the next day). The due from bank either credits the due to bank’s account or pays the due to bank directly with a bank draft. banks borrow under repurchase agreements and lend under resell agreements. returned checks. Clearings and exchanges are checks drawn on other banks. 128 . Banks should classify any federal funds transaction that matures in more than one business day as a loan. Due from bank accounts are correspondent banks that are used to collect checks. and at satellite locations. which should be disclosed separately). either at teller windows. The Federal Reserve credits the borrower’s reserve balance and charges the lender’s reserve balance. Each bank then makes the necessary charge to federal funds sold or purchased. Thus. These banks buy and sell federal funds to temporally redistribute total bank reserves. Cash items also include many other types of instruments that are considered cash equivalents.128 2. Federal funds may also be sold through collateralized transactions where a purchasing bank puts securities in a custody account until the funds are repaid to the seller. • • • 3. 2. Repurchase agreements (repos) and resell agreements (also known as reverse repurchase agreements or reverse repos) govern instances when a bank invests excess funds by buying securities from another bank or securities dealer. Cash on hand refers to funds in the bank. 4. in Automated Teller Machines (ATMs). 3. the borrowing bank agrees to repurchase the securities at the same price plus interest from the seller. in the vault. cash being collected. 5. and account balances with other banks (except material interest-bearing accounts. Federal funds are deposit balances held at Federal Reserve banks. usually less than one month. Settlement date accounting requires the bank to record both the purchase and sale of the securities and the income statement effects of the transactions. with costs disclosed. These interest bearing accounts are known as time deposits. Also. The financial statements should disclose savings account liabilities and certificates of deposit of $100. Interest Bearing Accounts 1. Traditionally. banks manually posted time deposit transactions on ledger sheets. Any changes in cost should be regarded as an unrealized gain or loss within net income.000 or more. it is acceptable to record the transactions as of the settlement date if the difference between the settlement date and trade date is not materially different. The types of accounts that bear interest include savings accounts. Securities and other investments with no ready market should be accounted for at fair value as determined by management. 4. How banks record securities transactions on their financial statements depends on whether the securities are purchased for trading purposes or for inclusion in the bank’s own investment account. However. Bank tellers also recorded the transaction in the customer’s passbook. Commercial banks can underwrite and initiate securities transactions. The total unrealized gain or loss is the difference between the total cost of the securities and their total fair value. Banks generally record securities transactions as of the trade date. 5. 3. Management should approve whether purchased securities belong in the trading account or the investment account. most banks use computergenerated ledger sheets to record transaction activity and account balances. Any material NOW account should also be disclosed.129 C. Trading Securities 1. 2. It is not advisable to record purchased securities in a suspense account and then later decide whether the securities are for trading or investment. D. negotiable orders of withdrawal (NOW) accounts. The decision on how to record the securities in the financial statement should be immediate. Banks should account for trading securities at market value. 2. Today. 3. banks 129 . Trading securities are securities that a bank intends to sell within a short period. and certificates of deposit. Increases or decreases in unrealized appreciation or depreciation should be included in the income statement. Banks should account for securities held for resale as follows: • • • Marketable securities should be accounted for at current market value. Rather. Loans 1. a write-down from cost to estimated market value should be charged to investment security losses at the time of the transfer. When this type of security has an unrealized gain or loss. 6. Banks can record interest earned on trading securities as either interest income or trading income. set limits on specific types of loans. for securities available for resale. Line-of-credit arrangements allow the borrower to borrow up to a maximum limit for a specific period. unrealized gains or losses are carried forward to future periods and adjusted based on the current fair value. Any securities intended for sale in the next year or operating cycle are classified as current assets on the balance sheet. the recommended method is to report interest income separately from trading income if the amount is material. Securities available for resale should be reported at fair value. commonly used for consumer credit cards. Also. State and federal regulations restrict the amount banks may loan to an individual borrower. In cases where banks transfer investment account securities to a trading account.130 should use market value to transfer securities from a trading account to an investment account. Demand loans have no fixed maturity date and are payable on demand of the lender. when recognized. Banks hold some securities with the intent of selling them in the future. 130 . and principal shareholders. and define the conditions governing loans to directors. the securities should be recorded in the investment account as a new acquisition. it may be necessary to include a note to the financial statements that discloses the major categories of securities in the trading portfolio. since the securities were not designated as part of the trading account at the original acquisition date. in this scenario. F. should be reported as investment security gains. E. Such gains. it is not reported on the income statement. Also. with any resulting gain or loss regarded as trading income. executive officers. they are classified as long-term assets in the investments portion of the balance sheet. The bank should not recognize the gain from the write-up of cost to estimated market value until final disposition of the securities. 2. is a typical line-of-credit arrangement. it is reported as a separate component of stockholders’ equity. 2. A revolving credit agreement. Securities Available for Resale 1. Otherwise. However. Bank loans can generally be classified in several ways: • • • Time loans are made for a specific time period. Commercial loans are typically made for business purposes to sole proprietors. Unearned discounts. partnerships. Some types of commercial loans include: • • • Short-term working capital loans generally finance the production needs of manufacturing companies until finished goods are sold. Interest on time. Interest income on loans is normally credited to operating income. Disclosure of these related-party transactions is required if they are material to the loan portfolio or in relation to total stockholders’ equity. Commercial loans may be written as short-term time loans. A real estate mortgage loan is an example of an installment loan. 3. There types of loans include the following: a. 6. 131 . and unamortized loan origination fees should be deducted from the loan balances. allowances for loan losses. banks often suspend accrual of interest. and real estate loans usually accumulates daily or monthly. Asset-based financing involves loans that are secured by the borrower’s current assets (receivables or inventories). If principal is paid on a loan after it has been placed on non-accrual status. Each type of loan typically has a separate general ledger control account that should be supported by subsidiary records. Many banks use ancillary ledgers to post all borrowers’ liability transactions. they should be presented as other liabilities. When a loan becomes delinquent or when collection seems unlikely. Depending on the type of subsidiary records used. if there are other unamortized loan fees that are material. 4. demand loans. demand. A loan is secured when the bank holds a lien against pledged collateral. 8. or term loans. and principal shareholders. 7. Customer overdrafts should be recorded as loans on the financial statements. Banks often make loans to officers. However. 5. single or multiple records may be needed to record loan information such as escrow balances or monthly payment amounts. directors.131 • Installment loans require periodic principal and interest payments. employees. Seasonal loans provide funds to businesses to carry them through off-season periods of the year. Accrued interest receivable is either included in other assets or stated separately. the bank must determine whether it should record the payment as a reduction of the loan principal amount or as interest income. A commercial loan may be secured or unsecured. and corporations. and other documentation and reporting requirements. Interest rates for residential mortgage loans may be fixed or variable. loan administration policies. deeds of trust. Floor-plan financing allows businesses that sell durable goods such as automobiles to finance inventories. the loan advance against those goods is repaid. but some secured card programs are available for customers that are a high credit risk. Borrowers whose loans are insured by the FHA pay an annual insurance premium based on their loan balance. land contracts. The Department of Veterans Affairs (VA) partially guarantees the loans of military veterans. Because of the extended maturity dates. Agricultural loans are common in rural areas and offer alternative financing to farmers who must often wait years before new operations begin turning a profit. Residential loans are usually secured by mortgages. may require amortization. VA loans feature little or no down payment and prohibit mortgage brokers’ commissions. both agencies require an appraisal by a certified or licensed real estate appraiser for transactions valued at $250. Many cards carry an annual fee and charge interest on balances unpaid after a specified period. term loans have a greater risk of loss. Automobile loans are a common type of installment loan. c. negative amortization. For this reason. or other types of real estate liens. term loans are usually secured. Lending institutions may require some borrowers to purchase credit life insurance to reduce the institution’s credit risk. and may contain other restrictive covenants. Most credit cards are unsecured. underwriting standards. Both the VA and FHA are required to establish lending policies that cover portfolio diversification standards. • 132 . appliances. or partial amortization with a balloon payment at a specified date. Two primary types of consumer loans are: • Installment loans allow the consumer to repay a loan over a set period. Credit cards allow customers to make purchases up to a set dollar limit. • • b. and home repairs or updates. Repayment of principal may be set up for full amortization. vacations. The Federal Housing Administration (FHA) insures the real estate loans of borrowers who qualify for the program.000 or more. educational expenses. Consumer loans cover personal use items such as automobiles. Also.132 • Term loans are extended-maturity loans that allow businesses to acquire capital assets. These loans are generally for smaller amounts and are repaid each month over the loan period. As the business sells goods. The loan is generally secured by the item being purchased. may be shown as loans on the balance sheet or in a separate caption. Banks own fixed assets. 2. However. Banks should use fair value to record assets acquired through foreclosure. collateral value on nonperforming loans. such as buildings. unless the investment is under $25. A bank’s holdings of real estate must not exceed a stated percentage of the bank’s capital and surplus.000 or is 5% or less of the bank’s equity capital. which is the risk that the borrowing entity’s exchange reserves will not be sufficient to meet its repayment obligations. H. and equipment. Most lease agreements give the lessee the option of purchasing the property at fair market value after the lease period ends.” The amount of the real estate should be listed as the lower of the annual value or the bank’s investment. Allowance for Loan Losses 1. International loans include loans made to foreign governments and banks. A national bank must sell any real estate within five years of acquisition if it is not used for banking purposes. e. the number of problem loans. These types of loans are subject to cross-border risk. 3. the fair value amount should not exceed the amount at which the investment was recorded. All banks assume some loans will not be repaid. guarantor’s financial strength. However. If the 133 . the reserve must be increased and the difference is charged to operating expenses. regulations set limits on the amount of fixed assets a bank may own. uncollectable loans should be written off and charged against the reserve for possible loan losses. The total amount of lease payments receivable plus the estimated residual value. historical loss experience. International loans are also known as foreign loans or cross-border loans. less unearned income and loss allowances. G. 2. Banks are required to estimate the amount of losses they expect from their loan portfolio. the quality of the loans made. for use in business operations. unless approved by regulatory authorities. A bank’s real estate holdings must be appraised each year. banks with assets under $25 million with a reserve account should charge uncollectable loans directly to operating expenses. Banks generally may not own rental property unless they are going to use the property for banking operations in the near future. In most case. If more funds than expected are needed to cover loan losses in a given period. Premises and Equipment 1. However. A commercial or consumer loan made by the foreign branch of a large bank is also considered an international loan. Leases allow a customer to use an institution’s property for a specified period. and the general state of the economy.133 d. land. A bank should record real estate not used for banking purposes on its balance sheet as “other real estate owned. Bank management sets the reserve at a given point based on factors such as the number and type of loans made. The issuing bank has three banking days to honor a demand for payment subject to a letter of credit.. Premises and equipment acquired after June 30. Amortization of a copyright usually is done in five years or less. Banks should use Generally Accepted Accounting Principles (GAAP) to capitalize and depreciate their fixed assets. Research and development costs associated with copyrights are treated as expenses. However. they are the ideas. I. Rather. transportation costs. The account for any fixed asset still in use that has not been capitalized according to GAAP should be reinstated along with the accumulated depreciation. Any accepted draft or bill of exchange under one of these agreements represents a liability to the bank. 2. Fair value is often synonymous with market value. J. 4. Customer Acceptances (Letters of Credit) 1. Letters of credit are usually valid for a period not exceeding six months. Common types of intangible assets are: • Copyrights prevent others from violating an entity’s proprietary rights to writings. should be stated at cost less accumulated depreciation or amortization. they are often used to prevent default. Legal expenses necessary to defend a copyright may be capitalized. The cost of a fixed asset should include all acquisition and construction costs (e. designs.g. Fair value is the amount a seller can expect to receive in a normal sale between a willing seller and willing buyer. Intangible Assets 1. 1967. Letters of credit state that a bank will guarantee payment on the drafts or bills of exchange of a person or entity. Intangible assets do not physically exist. and they may be revocable or irrevocable. or processes. and privileges that belong to an entity. Letters of credit can be used as a form of payment.134 recorded investment amount exceeds the fair value of the real estate. then the bank should record a loss. capacities. Only the customer can revoke an irrevocable letter of credit. 4. installation costs. Banks should classify any draft or Bill of Exchange they hold as a loan. 2. excavation costs. Supervisory agencies may deem it necessary to approve this entry because it could be considered a write-up of assets. However. 3. 5. a bank can revoke or modify a revocable letter of credit without the customer’s consent. 134 . and architects’ fees). expertise. Leasehold improvements are amortized over the remaining life of the lease or over the useful life of the improvement. government issues patents for a 17-year period. Goodwill is the establishment of a reputation and the perception among stakeholders and customers regarding quality of service.135 • Patents give owners exclusive rights to unique products or processes. Some of the accounts grouped under other assets include: • • • • • • • Accounts receivable Accrued interest receivable Accrued interest receivable Customers’ acceptance liability (described in an earlier section) Other real estate owned by the bank (described in the Premises and Equipment section) Unconsolidated investments in subsidiaries Suspense accounts 135 . Patents may be purchased or developed individually. are capitalized. Trademark development costs. Franchise fees paid in advance are capitalized and amortized over the useful life of this intangible asset. Trademarks are symbols that allow the public to easily recognize a product or company name. Leaseholds are amortized over the life of the lease. whichever is less. Leases allow one party to use another party’s property for a fee. except for associated research and development. Amortization of a trademark must be completed in less than 40 years. • • • • 3. Other Assets 1. Lease payments paid in advance are capitalized in the leasehold account. The U. A leasehold improvements account is set up to record any improvements made by the lessee. Most entities calculate depreciation using the straight-line method.S. K. Purchased patents are recorded at cost and developed patents are recorded at cost minus any costs for research and development. Franchises allow a franchisee to provide a company’s products or services. Intangible assets are initially recorded at cost. II. Owners of demand deposit accounts receive regular statements from their bank showing a record of deposits and payments during the previous period. Most banks now use ledger cards or computer-generated statements to account for activity on time deposit accounts. Banks record any check they write as a liability. Other types of time deposits accounts include certificates of deposit. 136 . although some types of checking accounts. Checking accounts and NOW accounts are known as types of demand deposit accounts. The teller then would record the transaction in the passbook. they may be presented in the balance sheet. 2. Deposits 1. and Keogh accounts. A. statement accounts. or point-of-sale (POS) terminals. The increased use of electronic banking has made passbooks nearly obsolete. automated teller machines (ATMs). LIABILITIES AND SHAREHOLDERS EQUITY Liabilities and equity are other important elements of the financial statements. Savings accounts have no stated maturity date.136 • Prepaid expenses and deferred charges 2. 3. Equity is the amount of assets that remain after liabilities are subtracted from assets. electronic funds transfers (EFTs). These types of accounts bear interest for a fixed period of time. A demand deposit account allows customers to safely and easily transfer money through the use of checks. usually accrue interest. The Federal Deposit Insurance Corporation (FDIC) insures funds held in all types of savings accounts. and money market accounts. Issued or certified items are listed in a check register and removed from the file after they are paid. Non-interest-bearing accounts typically include checking accounts and escrow accounts. such as negotiable orders of withdrawal (NOW) accounts. individual retirement accounts. Examples of savings accounts include passbook accounts. Savings accounts are a common type of interest-bearing account. This section discusses major types of liabilities and equity in the banking industry. Traditionally. passbook accounts required the customer to present a passbook when a transaction was made. In both cases the cash account is reduced only after the check is paid. Savings accounts are also known as time deposit accounts. Liabilities are probable future sacrifices of economic benefits due to present obligations or conditions. Banks also record a liability when they certify a customer’s check. When these other asset categories are material. Demand deposit accounts are federally insured. 137 Certificate of deposit (CDs) are sold with a specific maturity and rate of interest. Bearer CDs are payable to the owner, and registered CDs are payable to a specified person or entity. Negotiable CDs are short-term instruments generally purchased by companies and pension funds in large denominations. Negotiable CDs over $100,000 are regarded as money market instruments and are free from interest ceilings. Non-negotiable CDs are usually sold in smaller denominations. There is a penalty payable if the holder of a non-negotiable CD redeems the certificate prior to the maturity date. Individual retirement accounts (IRAs) and Keogh accounts are generally maintained as CDs. However, these accounts usually have long maturity dates because they are established as tax-deferred savings plans. 4. Posting of time deposit transactions usually occurs on the day the transaction occurs or the next day. During the posting process, banks may reject some transactions because they lack proper endorsements or are subject to stop payment orders. A bank may also reject a transaction if it would create an overdraft; these items are referred to holdover items or throwouts). B. Securities Sold Under Repurchase Agreements and Federal Funds Purchased 1. The federal funds market refers to transactions banks make for short-term financing purposes. Specifically, banks use interbank transactions to redistribute their financial resources on a short-term basis. Banks make unsecured loans to other banks by selling federal funds one day and being repaid for them the next day. Banks make collateralized transactions by placing U.S. government securities it purchases in a custody account until the seller makes repayment. 2. In a “securities sold under repurchase agreement” transaction, a bank sells U.S. government securities one day and repurchases them for the same price plus interest on the next day. Under this type of arrangement, the purchasing banks is said to entered into a “securities purchased under reverse repurchase agreement” transaction. 3. Federal funds transactions do not involve a physical transfer of funds. The Federal Reserve facilitates these transactions by making the appropriate credits or charges to the reserve accounts of the banks involved. The banks then make the appropriate credits or charges to their federal funds purchased or sold accounts. 4. Any federal funds transactions exceeding one business day should be treated as a loan. C. Other Borrowed Funds 1. Other types of borrowed funds include: • Short-Term Borrowing – e.g., commercial paper, lines of credit, and unsecured notes. 137 138 • • Debentures – unsecured debt securities issued by banks. Discounting or Advancing through Counts with a Federal Reserve Bank – Discounting involves the Federal Reserve rediscounting with recourse the bank’s eligible loans. Advancing occurs when member bank executes a promissory note using government securities as collateral; the term “discount” refers to the interest charged in these transactions. Treasury Tax and Loan Note Option Accounts – deposits held at a Federal Reserve bank that are subject to withdrawals and are supported by an open-ended, interestbearing note. Mortgages Payable – refers to indebtedness incurred to finance bank expansion programs. • • 2. Borrowings from the Federal Reserve are grouped with promissory notes and reported on the balance sheet as other borrowed funds. Debentures, subordinated notes, and mortgages payable are often included in separate liability categories on the balance sheet. D. Long-Term Debt 1. Common types of long-term debt include notes payable and bonds payable. Notes are debt instruments issued to a single investor. Bonds are debt instruments issued to multiple investors. Both notes and bonds have written agreements that describe the principal and interest payable. 2. Long-term debt instruments are sold at discount when the market rate exceeds the stated interest rate. An instrument is sold at a premium when the stated rate exceeds the market rate. An instrument is sold at face value when the market rate and stated rate are equal. 3. The “discount on bonds payable” account is debited when a bond sells at discount. The “premium on bonds payable” account is credited with a bonds sells at a premium. The discount or premium is amortized over the life of the bond. 4. Bond issuance costs, such as costs for underwriting fees, printing, and advertising, should be charged to a prepaid expense account. 5. Volume IV of this CFSA Study Guide is devoted to issues and concepts related to the securities industry, including long-term debt instruments. E. Preferred/Common Stock 138 139 1. Preferred stock and common stock make up a part of a bank’s total capital. However, regulations limit the amount of equity a bank may have in relation to the bank’s size and asset mix. 2. When only one class of stock is issued it is classified as common stock. When two classes of stock exist they are classified as common and preferred. 3. Banks can account for stock dividends in two ways: • • by transferring from retained earnings to capital stock an amount equal to the par value of the additional shares being issued by transferring from retained earnings to a category of permanent capitalization an amount equal to the fair value of the additional shares issued 4. Stock dividends are recorded at the fair market value of the stock on the date the dividend was declared. 5. Volume IV of this CFSA Study Guide is devoted to issues and concepts related to the securities industry, including preferred and common stock. F. Retained Earnings 1. Retained earnings are the accumulated revenues and expenses of a bank. Therefore, this account increases or decreases based on fluctuations in earnings and dividend distributions. 2. Net losses reduce retained earnings and net income increases retained earnings. Prior period adjustments to correct financial statement errors from a previous period can either increase or decrease retained earnings. The payment of dividends serves to decrease retained earnings. G. Treasury Stock 1. The term treasury stock refers to outstanding stock that a corporation reacquires or repurchases. Corporations can use treasury stock to prevent against takeover by other companies or to facilitate the takeover of another company. Outstanding stock is also reacquired to meet the needs of employee stock option plans. 2. Treasury stock reduces shareholders’ equity and is deducted from the contributed capital and earned capital lines on the balance sheet. 3. Reacquiring outstanding shares increases a corporation’s earnings per share by reducing the number of shares outstanding. 4. Dividends are not paid on treasury stock. 139 140 5. Treasury stock can be recorded at cost or at the stated (or par) value. III. OTHER SERVICES/OPERATIONS This section discusses some other bank services and operations. These include payroll/employee benefits, automated clearinghouses and wire transfers, branch operations, trusts, investment products, asset/liability management, derivatives, and statement of cash flows. Proper management of these services and operations is necessary to reduce the risk of a negative effect on the financial statements. A. Payroll/Employee Benefits 1. Salaries are one of the largest operating expenses in many banks. Losses can occur if a bank does not have adequate controls over this function. 2. The largest risks banks face in this function are making salary payments to employees no longer on the payroll; paying employees for unearned overtime, sick time, or vacation time; entering improper or unauthorized salary increases into the system; and miscalculating Social Security or income tax deductions. Additional risks include failing to monitor employee benefit providers and compliance with federal regulations. B. Automated Clearing House and Wire Transfer 1. The Automated Clearing House (ACH) is method banks use to move money electronically. The ACH receives, records, and facilitates debit and credit transactions between banks. 2. Some of the transactions the ACH facilitates include direct payroll deposits, government payments, pension payments, dividends, direct debits, corporate cash disbursements, and corporate payments. 3. Wire transfer systems are another method of electronic funds transfer. Transferring funds by wire is immediate and irrevocable. 4. FedWire and CHIPS provide the majority of wire transfer services in the U.S. The Federal Reserve operates FedWire. CHIPS is operated by the New York Clearing House for use by banks in the New York area. 5. The following terms are associated with the Wire Transfer Function:1 • Correspondent Banks – Financial institutions that maintain account relationships with each other. 140 141 • • • Credit Party – The party to be paid by the receiving financial institution. Draw Down – An instruction to reduce the balance of the sender’s account serviced by the receiver with a payment to the sender’s account at another financial institution. Execution Date – The day on which the sending bank may properly issue a payment order in execution of the originator’s orders. The execution date may be determined by the originator, but cannot be earlier than the day the order is received and, unless otherwise determined, is the day the order is received. Federal (Fed) Funds – United States dollars on deposit at a Federal Reserve Bank. Fed funds are commonly used to refer to the transfer (sale/purchase) of excess balances between financial institutions for a stated period of time. Intermediary Bank – A financial institution to which funds are transferred for further credit to the beneficiary’s bank. Immediate Funds – Funds available immediately. Initiator – The originator or an agent of the originator of the transfer instructions. Methods of Initiation – The transfer instructions can be transmitted by various means, including electronic initiation systems, orally (e.g., in person or by phone), and writing (e.g., hand or mail delivery or fax). Payment Order – An instruction of an originator to a sending bank, transmitted orally, electronically, or in writing, to pay or to cause another bank to pay, a fixed or determinable amount of money to a beneficiary. PUPID (Pay Upon Proper Identification) Wire – A PUPID is an incoming wire transfer with instruction to pay the beneficiary upon presentment of proper identification. The beneficiary usually does not maintain a checking or savings account with the paying financial institution. Receiving Bank – The financial institution receiving funds from the sender on behalf of the beneficiary. Remitter – A general term meaning the source of funds in a payment order. Repetitive Transfer – A transaction for which all information has been established on the funds transfer system and assigned a unique identifier to be accessed and transferred upon the customer’s request. The dollar amount and date are the only variables in the transfer. • • • • • • • • • • 141 142 • • • Same Day Funds – Funds available for transfer today subject to settlement of the transaction through the payment mechanism used. Sending Bank – The financial institution that inputs the transaction into a funds transfer system or message service such as FedWire. SWIFT (Society for Worldwide Interbank Financial Telecommunications) – A private international telecommunications network for transmitting and routing financial messages. SWIFT carries messages only and does not provide settlement. Test Key – A code between the sender and the receiver used in a message to validate the source and/or amount, date, etc. Transit Routing Number – A financial institution’s identifier with the Federal Reserve Bank. Value Date – Date upon which funds are to be available to the receiving bank. • • • C. Branch Operations 1. Each state has established its own regulations regarding branch banking. Note: some banks operate under a national charter and are regulated by the Office of the Comptroller of the Currency. Therefore, state regulations may not apply to these banks. 2. The Interstate Act of 1994 allows interstate branch banking through the merger of banks in the same state owned by the same holding company. However, states retain the authority to disregard the Interstate Act and prohibit branch banking. 3. A de novo branch bank is a new branch not resulting from a merger. The Interstate Act permits states to adopt legislation allowing de novo branches on the condition that the state must also permit de novo branches of banks headquartered in other states. 4. The Federal Reserve Board governs the foreign activities of U.S. banks. Board approval is required before a foreign bank subsidiary can establish an initial branch in its first two countries outside its own country. Banks must also advise the Board regarding plans to establish additional branches in that country. Foreign branches of member banks may engage in the same banking activities allowed the member bank under U.S. banking law and its charter. D. Trust 1. Trust departments administer trusts, estates, pension accounts, profit sharing accounts, and custodian accounts. The Board of Directors has fiduciary responsibility for any trust funds 142 143 the bank holds.) for persons that specify no executor in a their will or whose named executor is unable or unwilling to serve. 2. The Board or its designees must accept in writing all trust funds held. Banks provide the following personal trust services for individuals: • Estate Settlement – Banks serve as executors or administrators of estates. and inventory the deceased person’s assets. control. Funds held in trust accounts are not assets of the bank. investment advisory agent. or safekeeping agent. Courts can also appoint a bank to serve as administrator cum testamento annexo (c. records relating to trust accounts must be segregated from other bank accounts. Banks may also be appointed to serve as guardians of assets for adults who are deemed incompetent or unable to manage their money. Serve as Agent – A bank serves as agent when the bank takes possession of a piece of property but the owner retains the title. “Charitable trusts” are established by will or agreement for religious. taxes. Therefore. 5.a. The assets of any trust account accepted must be reviewed at least once every 15 months. Banks must keep trust account records for three years after their fiduciary relationship ends. 3. Funds a bank holds in trust cannot be reinvested in the bank’s own securities. Trust Development – The bank may be specified as trustee under a “trust by agreement” arrangement. or community improvement purposes. Agency accounts at a bank include when the bank serves as custodian of property. educational. Serve as Co-Fiduciary – Some wills specify that more than one responsible party share the trustee responsibilities of an estate. and claims. Banks may transfer funds from one trust account to another unless prohibited by a trust agreement or unless it is unfair to either account. • • • • 143 . and distribute the net remaining estate according to the terms of the will. As administrator of an estate. “Trusts by court order” occur when the courts appoint the bank as trustee for a designated person. A bank also serves as agent when it executes any authorized powers of attorney. arrange to pay applicable costs. “Trust by declaration” occurs when the bank makes a contract with a third party agree to be trustee for someone else’s property.t. the bank’s major duties are to assemble. The named parties are referred to as cofiduciaries. escrow agent. All bank employees participating in trust operations must be bonded. 4. “Trusts under will” occur when a will names the bank as a trustee of property for another party named in the will. Serve as Guardians of Estates – Courts may direct a bank to hold and manage the assets of a minor until he or she is of legal age. Additional duties of corporate trust departments include: • • • • Stock Transfer Agent – The transfer agent may issue stock certificates to increase shares outstanding or reissue new certificates when ownership changes. Self-Employed Retirement Trusts – Banks may serve as trustee or custodian for pension and profit sharing plans that self-employed individuals establish for themselves and their employees. A bank must also ensure 144 . are known as “defined benefit plans. paying dividends. Corporations. and mailing notices and proxies to stockholders. 7. • • 8. A bank may serve as the administrator. These types of trusts are referred to as Keogh plans. Stock Registrar – The stock registrar checks new issues and transfers to prevent overissuance. which must occur between the ages of 59½ and 70½. Individual Retirement Accounts (IRAs) – Banks may administer IRA accounts in accordance with individual agreements with customers. co-trustee. Types of retirement plans that banks may administer include: • Pension Plans – These plans provide retirement income for employees. On the other hand. and any additional contributions are tax deductible until withdrawals begin.” which are plans funded either at a fixed rate (often based on a percentage of an eligible employee’s salary) or at the discretion of company’s directors. A trust agreement or “indenture” specifies the bank’s responsibilities. redemption. maintaining accurate records. Pension plans that an employer establishes for retired or disabled employees. the PBGC does not insure “defined contribution plans. Defined contribution plans include profit-sharing plans and stock bonus plans. Banks must establish standards for accepting signatures. witnessed. and dated. and recordkeeping functions associated with a stock or bond issue. so employees assume no investment risk for any portion they contribute. transfer. custodian. Transfer agents must verify that certificates are unaltered and properly endorsed.144 6. A bank’s corporate trust department handles the functions related to stocks and bonds. and other organizations use banks as trustees to handle the issuance. Bond Registrar – The bond registrar is responsible for registering bonds at issue. handling stock subscriptions and exchanges. agent.” The Pension Benefit Guarantee Corporation (PBGC) insures this type of plan. Individuals do not have to pay taxes on deferred income. government entities. trustee. Dividend Reinvestment Agent – The dividend reinvestment agent receives a stockholder’s dividends and purchases additional shares on the stockholder’s behalf. Banks may serve as a “transfer agent” to perform services such as recording stock ownership changes. regardless of whether an employee contributes. or depository for a company’s employee benefit and retirement plans. Banks are allowed to purchase no more than 10 percent of their capital and surplus from one source of Type III security. 2. Banks are allowed to purchase no more than 10 percent of their capital and surplus from one source of Type II security. • • • 145 . Investment products are either short-term or long-term. The Comptroller of the Currency restricts the types of security investments that national banks can make. 9. The balance sheet should show marketable equity securities at either the lower of aggregate cost or aggregate market value. short-term investments include savings accounts. Short-term investments qualify as current assets if they are marketable and easily liquidated. Inter-American Investment Corporation. Banks are allowed to purchase no more than 25 percent of their capital and surplus from one source of Type IV security. These securities are also known as “bank-eligible securities” because banks can invest in them without restriction. Investment Products 1. Investment securities should be shown at cost. the names and addresses of the registered owners. Marketable debt securities are carried at cost. with adjustments for premium amortization and discount accretion. Treasury bills. Examples of Type IV securities include certain residential and commercial mortgagerelated securities. and the cancellation date. State obligations issued for housing. E. 3.S. Inter-American Development Bank. Type III Securities – These are investment securities that do not fall under one of the other four types of securities. The registrar accounts for all shares issued. The registrar’s duties include ensuring that old certificates are properly cancelled and that new certificates are properly issued in the correct numerical sequence. investments are considered long-term and are classified as noncurrent assets. securities are divided into five types: • Type I Securities – This category of security is backed by the full faith and credit of the U. Type IV Securities – These are securities composed of interests in a pool of loans. certificates of deposit. or dormitory purposes are also considered Type II securities. and certificates cancelled. The role of the registrar is to ensure that transfer agent does not issue too many shares. African Development Bank. Otherwise. university. Banks also serve as “registrar” for stock and bond issues. the number of shares of stock or the principal dollar amount of debt issued. and Tennessee Valley Authority. In general. certificates outstanding.145 that certificates include the certificate number and date issued. and marketable stocks and bonds. government. For this purpose. Type II Securities – This category of security includes obligations of the World Bank. 2. Asset/liability management (ALM) is a short. However. • • 146 . ALM tries to create optimal risk/reward decisions and focuses on creating prices that achieve a desired spread. For example. In developing these policies bank officials review historical financial reports. and other available information. 3. the income statement. Capital Risk – Banks must maintain adequate capital levels. an interest-rate swap occurs when one party trades a variable interest rate for a fixed rate. Banks should develop policies related to ALM. the balance sheet. Interest-Rate Risk – Earnings and capital can fluctuate due to changes in interest rates. retaining too much capital can reduce the bank’s growth potential. Asset/Liability Management 1. Banks are allowed to purchase no more than 25 percent of their capital and surplus from one source of Type V security.146 • Type V Securities – These are marketable investment grade securities that are not Type IV. but loans are also riskier. Liquidity Risk – Banks must maintain some liquid assets. Options – An option gives a party the right to buy or sell a financial instrument at a fixed price up to a set amount during a specified period. Types of derivatives include: • Swaps – A swap occurs when two parties exchange streams of payments for a set period of time. liquidity reports. Futures Contracts – A futures contract specifies an amount of a commodity or financial instrument to be delivered at a specified future date.and long-term planning tool designed to maximize earnings. A derivative is a financial contract whose value depends on the value of other assets. A sound ALM policy must manage four types of risks: • • • • Credit Risk – Loans are more profitable than most investments. Use of Derivatives 1. F. L. or vice versa. including specific guidelines regarding risk/reward tradeoffs. ratio reports. but not too much because liquid assets typically draw little or no interest. Derivatives can be effective. except there is no exchange acting as intermediary. A statement of cash flows reports the cash receipts. 4. Examples of cash equivalents include Treasury bills. 3. 2. no daily settlement. and no margin. M. investing activities. The term “cash” refers both to cash and cash equivalents. The statement reconciles beginning and ending cash balances. • 3. Cash equivalents are short-term investments that are readily convertible to cash. and commercial paper. banks should have adequate oversight by senior management and the board of directors. and financing activities of the bank. The SEC requires certain disclosures for entities that use derivatives. The function of the statement of cash flows is to show the bank’s ability to generate future cash flows and to meet its financial obligations. 147 . although some banks may experience losses due to interest rate changes. money market funds. Outside of the financial statements. and the net change in cash resulting from the activities of a bank during a given period. they are relatively insensitive to interest rate changes. cash payments. In order to manage risks. Because these are short-term investments. Statement of Cash Flows 1. The operating section appears first. The information should be separated into two categories: derivatives used for trading and derivatives used for other purposes.147 • Forward Contracts – A forward contract is similar to a futures contract. These required disclosures include: • If derivatives are material. The information should address the extent derivatives are exposed to market risk and the methods the entity uses to manage the market risk. entities should provide quantitative and qualitative information about derivatives for investors. or other fluctuations. low-cost tools for managing exposure to risks. commodity price changes. 2. The statement of cash flows reports on the operating activities. as well as a comprehensive policies and procedures governing the use of derivatives. the notes to the financial statements should include a descriptions of the types of derivatives used and a discussion of the method used to account for derivatives. followed by the sections on investing activities and financing activities. “Primary markets” deal in new issues of securities. A bank can lend money up to a specified amount based on the size of its excess reserves. mortgages. The financial markets help keep the economy function by giving individuals and businesses the opportunity to transfer and borrow money. the interest rate influences the cost of money. and funds in checking accounts. Thus. Role of Money and Banking 1. A. government bonds. Therefore. MONEY AND BANKING This section provides a brief introduction to the concepts of money and banking and how money relates to the banking industry.g. typically refers to paper money. if prices rise.S.S. 5. “Near-monies” are highly liquid assets such as savings accounts and U. 2. 148 . Banks can increase the money supply and stimulate the economy through the funds its invests and loans. and “secondary markets” trade in shares outstanding. If prices fall. Broadly defined. The money supply in the U. High inflation causes interest rates to rise. The riskier the loan. 3. their interest rates are usually lower than long-term rates. Effect of Interest Rate Movements 1. Interest is the amount paid to borrow funds.148 IV. Volume IV of this Study Guide addresses the subject of financial markets in more detail.S. There are two types of financial asset markets. Bond and Stock Markets 1. 4. 2. are the formal security exchanges (e. B. and loans.. C. The two types of stock markets in the U. 3. the New York Stock Exchange) and the “over-the-counter” market. such as occurs when a company sells its stocks or directly to the public. Money has value in relation to its purchasing power. money is anything of value that can function as a medium of exchange. The “real interest rate” refers to the stated rate adjusted for inflation. Because short-term loans are less risky. coins. Money can be transferred directly between individuals or companies. 2. the value of money increases. the higher the interest rate. the value of money falls. Based on the theory that lower interest rates encourage investment. the Federal Reserve can control the money supply and credit availability in the U. Interest rates also increase as the federal deficit increases. Lower interest rates serve to stimulate investment activities. Change Legal Reserve Requirements – Increasing legal reserve requirements decreases the amount of money that a bank has available to lend. if the Federal Reserve wished to decrease the money supply to try to reduce inflationary pressures.149 4. government borrows or prints money. 149 .S. The Federal Reserve’s monetary policies described above are designed to influence investment spending. Interest rates rise when the U.S. Therefore.S. in the following ways: • Change the Discount Rate – The discount rate is the rate the Federal Reserve charges member banks to borrow funds. Decreasing the discount rate stimulates borrowing among member banks (which then lend more to customers). Monetary Management Theories 1. High interest rates in foreign countries also contribute to high interest rates in the U. and vice versa. Thus. it would increase the discount rate to discourage borrowing. Buy or Sell Securities on the Open Market – The Federal Reserve buys government securities to increase the reserves of member banks and sells government securities to decrease in member banks’ reserves. D. Moral Suasion – The Federal Reserve issues oral or written statements to encourage banks to increase or decrease their lending activities. increasing the legal reserve requirements decreases the money supply. • • • 2. Federal Reserve System – The Federal Reserve. In addition. (3) maintaining the stability of the financial system. the overall banking system functions well. Although. the central bank of the United States. To facilitate the review of current laws and regulations. government. and foreign official institutions. Overview of the Regulatory Environment B.The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. and more stable monetary and financial system. and compliance with the intent of banking laws and regulations helps the system function effectively and protects the interests of consumers and shareholders. more flexible. Legislation has been enacted to serve the interests of consumers and the entities involved in commercial banking activities. was founded by Congress in 1913 to provide the nation with a safer. The primary regulatory entities for banking include: • • • • • Federal Reserve System Office of the Comptroller of the Currency Federal Deposit Insurance Corporation (FDIC) State Regulatory Systems National Credit Union Administration (NCUA) 1. There are thousands of laws and regulations that affect banking. but a member who has been appointed to complete an unexpired 150 . the public. there are multiple competing interests that vie for changes to banking laws to accommodate their interests. and (4) providing certain financial services to the U. Laws and Regulations A. Appointments to the Board .150 UNIT 2: LAWS/REGULATIONS AND REGULATORY ENVIRONMENT The banking industry is heavily regulated. financial institutions. Members may serve only one full term. The sections for this unit are: A.S. and this unit will provide a snapshot of a small sample of these regulations. web sites to provide current and detailed information have been included throughout this unit. Today the Federal Reserve's duties fall into four general areas: (1) conducting the nation's monetary policy. excerpts from the actual text of some laws and regulations has been included. Overview of the Regulatory Environment The banking industry is regulated by the entities listed below. (2) supervising and regulating banking institutions and protecting the credit rights of consumers. These two functions plus open market operations constitute the monetary policy tools of the Federal Reserve System.The Board usually meets several times a week.The primary responsibility of the Board members is the formulation of monetary policy. Edge Act and agreement corporations.Only one member of the Board may be selected from any one of the twelve Federal Reserve Districts. and the U. The Board also sets margin requirements which limit the use of credit for purchasing or carrying securities." These aspects of selection are intended to ensure representation of regional interests and the interests of various sectors of the public. In making appointments. industrial. Another area of Board responsibility is the development and administration of regulations that implement major federal laws governing consumer credit such as the Truth in Lending Act. the group that makes the key decisions affecting the cost and availability of money and credit in the economy. members of Congress and academicians. The other five members of the FOMC are Reserve Bank presidents. for four-year terms. the Board plays a key role in assuring the smooth functioning and continued development of the nation's vast payments system. and the Senate confirms. If the Board has convened to consider confidential financial information. The other Bank presidents serve one-year terms on a rotating basis.As they carry out their duties. they meet frequently with Treasury officials and the Council of Economic Advisers to help evaluate the economic climate and to discuss objectives for the nation's economy. representatives of banking industry groups. Meetings are conducted in compliance with the Government in the Sunshine Act. and commercial interests and geographical divisions of the country. Meetings . the Equal Credit Opportunity Act. Responsibilities . By statute the FOMC determines its own organization. and many meetings are open to the public.S. activities of foreign-owned banks. agricultural. In addition. members of the Board routinely confer with officials of other government agencies. the sessions are closed to public observation. Contacts within Government . For example. officials of the central banks of other countries. foreign activities of member banks. bank holding companies. The President designates. 151 . two members of the Board to be Chairman and Vice Chairman. agencies that make foreign loans and conduct foreign financial transactions. the Home Mortgage Disclosure Act and the Truth in Savings Act. Governors also discuss the international monetary system with central bankers of other countries and are in close contact with the heads of the U. and by tradition it elects the Chairman of the Board of Governors as its Chairman and the President of the New York Bank as its Vice Chairman. one of whom is the president of the Federal Reserve Bank of New York.S. international banking facilities in the United States. The seven Board members constitute a majority of the 12-member Federal Open Market Committee (FOMC). however. Representation . the Federal Reserve Board has supervisory and regulatory responsibilities over banks that are members of the System. The Board sets reserve requirements and shares the responsibility with the Reserve Banks for discount rate policy.151 term may be reappointed to a full term. the President is directed by law to select a "fair representation of the financial. In addition to monetary policy responsibilities. Members of the FRS are required to maintain a certain percentage of cash-reserves in their vault or in non-interesting bearing accounts at FRS bank. Ability to use FRS regional check processing centers. bank investments. It also supervises the federal branches and agencies of foreign banks. including the Community Reinvestment Act. and supervises all national banks. capital. D. Department of the Treasury. legal interpretations. They review the 152 . and corporate decisions concerning banking. Although membership is not required for state chartered banks. The OCC is headed by the Comptroller. 2. Ability to use the FRS automated clearing house. Ability to request current information on banking issues.152 (The information above was taken from the Federal Reserve System Web site on November 6. National banks are obligated to be members of the FRS. Regulation I outlines the amount of stock that must be purchased by an individual bank.C. The OCC’s nationwide staff of examiners conducts on-site reviews of national banks and provides sustained supervision of bank operations. Office of the Comptroller of the Currency – The Office of the Comptroller of the Currency (OCC) charters. liquidity. Ability to use the FRS check clearing system. for a five-year term. Examiners analyze a bank’s loan and investment portfolios. the OCC has six district offices plus an office in London to supervise the international activities of national banks. The amount is generally a percentage of the bank’s capital and surplus. The Comptroller also serves as a director of the Federal Deposit Insurance Corporation (FDIC) and a director of the Neighborhood Reinvestment Corporation. and other aspects of bank operations.htm) Banks must purchase the stock of bank in its district to be a member of the Federal Reserve.. funds management. with the advice and consent of the Senate. 1999 . many are members of the FRS.http://www. who is appointed by the President. The OCC was established in 1863 as a bureau of the U. and compliance with consumer banking laws. This is called the member’s rate.S. Headquartered in Washington. sensitivity to market risk. Some advantages of being a member of the Federal Reserve System include: • • • • • • • Ability to borrow funds from the Federal Reserve at a discount rate. Right to store securities at Reserve banks at no charge. The agency issues rules.gov/general. National bank examiners supervise domestic and international activities of national banks and perform corporate analyses.federalreserve. regulates. bank community development activities. earnings. lending. OCC Funding . History . the OCC regulates and supervises more than 2. Treasury securities. The four objectives are: • • • • To ensure the safety and soundness of the national banking system. they continue to play a prominent role in the nation’s economic life. 153 . including reducing regulatory burden.The OCC’s activities are predicated on four objectives that support the OCC’s mission to ensure a stable and competitive national banking system. commercial banks. internal and external audit. and issue cease and desist orders as well as civil money penalties.153 bank’s internal controls. and compliance with law. capital. Issue rules and regulations governing bank investments. National banks pay for their examinations. Approve or deny applications for new charters.600 national banks that hold about 58 percent of the total assets of all U.In the National Currency Act of 1863. That act authorized the Comptroller of the Currency to hire a staff of national bank examiners to supervise and periodically examine national banks. Although national banks no longer issue currency. the Comptroller of the Currency. To improve the efficiency and effectiveness of OCC supervision. and they pay for the OCC’s processing of their corporate applications. One of the reasons Congress created a banking system that issued national currency was to finance the Civil War. Today. To ensure fair and equal access to financial services for all Americans. the OCC has the power to: • • • Examine the banks. In regulating national banks. To foster competition by allowing banks to offer new products and services.The OCC does not receive any appropriations from Congress. negotiate agreements to change banking practices. The law was completely rewritten and re-enacted as the National Bank Act. the administration of the new national banking system was vested in the newly created OCC and its chief administrator. The OCC also receives revenue from its investment income.S. Instead. branches. • The OCC’s Objectives . Take supervisory actions against banks that do not comply with laws and regulations or that otherwise engage in unsound banking practices. or other changes in corporate or banking structure. The act also gave the Comptroller authority to regulate lending and investment activities of national banks. The agency can remove officers and directors. primarily from U.S. its operations are funded primarily by assessments on national banks. and other practices. They also evaluate bank management’s ability to identify and control risk. 154 FDIC Insurance .The FDIC insures the deposits in all national banks. The OCC’s primary function is the supervision and examination of national banks. Below is a list of banking circulars: Date 11/07/93 09/03/93 06/16/93 05/25/93 05/21/93 02/25/93 01/05/93 12/03/92 07/14/92 03/05/92 02/27/92 05/14/93 03/19/93 01/05/92 03/13/93 07/30/91 09/12/90 02/07/90 10/27/93 10/27/93 10/14/92 04/18/91 06/08/90 09/07/89 05/10/89 02/03/89 05/31/88 01/25/88 11/21/86 10/31/86 09/11/86 06/18/86 07/26/85 05/22/85 05/23/85 05/07/85 05/07/85 Title Risk Management of Financial Derivatives Free Riding In Custody Accounts Civil Money Penalties EFT Switches and Network Services Civil Money Penalty for Delinquent/Inaccurate Call Prompt Corrective Action FFIEC Statement: Large Funds Transfer for Money Laundering National Bank Fair Lending Efforts EDP Service Contracts Stock Appraisals External Fraud External Fraud . The OCC also issues banking bulletins and circulars to inform the banking community of regulations. Government Guaranteed Loans Securities Lending 154 . The OCC has a role in coordinating banking examinations among different federal regulatory agencies.Central Bank (Denver) Certificates External Fraud External Fraud External Fraud Troubled Loan Workouts and Loans to Borrowers Application of Securities Laws to Common Trust Funds Suspicious Transactions Suspicious Transactions .S. Information Security End-User Computing Investment In Investment Co's Composed of Bank Eligible Sweep Fees Securities Denominated In Foreign Currencies Collateral Evaluation and Classification of Energy Loans OCC Staff No-Objection Positions Accounting for Loan Swaps Loan Production Offices Premiums on U. An individual is limited to $100.000 in insurance coverage at each bank (including all branches).Pethahiah Suspicious Transactions Suspicious Transactions Suspicious Transactions Push Down Policy International Payments Systems Risk Acceptance of Financial Benefits by Bank Trust Depts.Depository Trust Suspicious Transactions . adopting standards for developing regulations that apply to all the rules that the agency issues. the payments system. The OCC eliminates regulatory requirements that are not necessary to ensure the safety and soundness of national banks. In assessing how to regulate a particular activity and the need for regulation in that area.Sale of Commemorative Coins 07/01/76 .Bank Holding Company Affiliates 01/14/70 . or to accomplish other aspects of the OCC's statutory mission. the OCC takes into account changes in banking organizations' structures and the impact of technology on how banks deliver products and services.155 Financial Information on Data Processing Servicers Issuance of "Due Bills" to Customers Purchasing Securities Purchases of Loans In Whole or In Part-Participations Federal Home Loan Mortgage Corporation (FHLMC) Swap Program Charges by a Federal Reserve Bank Against a NB Service Charges on Dormant Accounts Abandoned Property Law Uniform Class. the Office of the Comptroller of the Currency issued OCC Bulletin 978. In this way.II 01/14/70 .Purchase of Shares In the Common Stock 01/18/85 03/07/84 08/02/84 06/11/82 04/09/82 09/25/80 04/26/91 10/18/76 - Standards for Developing Regulations On January 21. consider how nonbanks performing comparable functions are regulated and then assess the potential for alternative regulatory approaches to be applied to the regulation of national banks. 155 . Those standards are based on the standards that the OCC used in the comprehensive revision of its regulations under its Regulation Review Program. Regulations are risk-focused if they effectively target the areas of bank activity that present the greatest risk to safety and soundness. In developing regulations. The OCC seeks to identify regulatory and supervisory goals that will remain valid even as banking structures change and the means by which banks operate and serve their customers evolve. Regulations are results-oriented if they focus on the achievement of key regulatory or supervisory objectives rather than mandating compliance with detailed steps leading up to those objectives. of Assets & Appraisal of Securities Exception to Lending Limits for OPIC Insured Standby Letters of Credit Issued by National Banks 11/03/81 . and when they address areas where either banks or the OCC have clearly established statutory responsibilities. the OCC will. or the long-term vitality of the national banking system.Coin and Bullion 12/28/83 . to support consumers' access to financial services. when appropriate. the OCC ensures that its rules set the standards for the effective supervision of national banks without stifling banks' ability to undertake innovation or accommodate change. 1997.National Banks May Make Investments In National Housing Partnership .NB’s May Make Investments In Partnerships In Which the Housing Partnership is a Partner 01/14/70 . or other objective factors. In each case. a combination of approaches is best. and reasonably prompt. The OCC's regulations establish application criteria and procedures that allow maximum flexibility for the strongest banks and closer scrutiny and controls for banks with demonstrated weaknesses. instead. some regulatory requirements impose disproportionately greater burdens on small banks. and the Office of Thrift Supervision) and with other financial services regulators to achieve consistency in the way national banks and their competitors are regulated in the conduct of the same or similar activities. the OCC uses the approach best suited to the subject of the rule. The OCC facilitates participation in its rulemakings by banks and members of the public by allowing time for thoughtful comment. Absent unusual circumstances. Some regulations may appropriately prescribe a bright-line standard. CAMEL ratings. including by facsimile transmission and electronic mail. The OCC's regulations provide for processes that are predictable. When possible. Therefore. the OCC balances banks' need for a predictable response from the regulator against the goal of providing maximum flexibility to bank management consistent with principles of safety and soundness and other statutory requirements. the OCC may vary regulatory requirements according to these differences. the OCC allows a comment period of not less than 60 days. In drafting its regulations. so that banks know what is necessary in order to request OCC approval. Differential regulation means that requirements are not imposed on a "onesize-fits-all" basis. reporting or recordkeeping requirements may differ depending on a bank's size or risk levels. Regulatory burden and cost result if bankers must always seek the advice of experts in order to understand the requirements that apply to them. orderly. The OCC accepts comments in a variety of formats. the OCC uses a differential regulatory approach when appropriate to the issue under review. which provides the greatest certainty to banks about the limits of acceptable conduct. tailored to the condition or characteristics of different categories of national banks. Moreover. In some instances. Often. so that banks can plan appropriately. the Federal Deposit Insurance Corporation. National banks operate in a competitive environment in which providers of financial services are subject to different regulatory schemes administered by different federal and state agencies. The OCC writes regulations in a clear. but are. Other regulations may contain more general standards that offer banks greater flexibility but reserve more discretion to the OCC. so that banks do not lose competitive opportunities as a result of unnecessary regulatory delay. size. Similarly.156 To minimize the burden that results from requirements that are necessary for effective supervision. The OCC uses sparingly the 156 . risk levels are often dependent upon differences in banks' capital levels. the OCC consults and coordinates with the other federal banking agencies (the Board of Governors of the Federal Reserve System. plain style and structures regulations to enhance their clarity. national banks must apply to or consult with the OCC before expanding their lines of business or undertaking certain activities. For example. would be safe and available to them on demand.157 discretion it has under applicable laws to dispense with prior notice and opportunity for comment. The FDIC sign. and its own staff to provide feedback on how its regulations are working. 1934.000 banks closed between the stock market crash of October 1929 and March of 1933. (The information above was taken from the Office of the Comptroller of the Currency Web site on November 6. professional. declared a "banking holiday" suspending all banking activities until stability could be restored.gov) 3. the FDIC has insured deposits and promoted safe and sound banking practices since 1933. Mission . and solicitation of comment on a continuing basis via the Internet. less than 48 hours after his inauguration. participation by the Comptroller and senior members of the agency's staff in outreach or focus group meetings with bankers and public interest groups. Introduction . The OCC uses a variety of mechanisms to obtain feedback either directly or indirectly. or technology. The intent was to provide a federal government guarantee of deposits so that customers' funds. the OCC times the effective dates of its regulations to allow an adequate period for national banks to adjust their data systems and business planning processes to accommodate change. within certain limits.The FDIC's mission is to maintain the stability of and public confidence in the nation's financial system.The Great Depression of the late 1920s and early 1930s caused financial chaos in America. or public interest groups. This publication describes why and how the FDIC fulfills its mission. when President Franklin Delano Roosevelt took office.treas. You also will learn where to turn for more information at the FDIC. 1999 . intra-agency updates and feedback via meetings and electronic mail. To achieve this goal. not one depositor has lost a cent of insured funds as a result of a failure. 157 . The OCC is committed to keeping its regulations current. For all practical purposes. members of the public. Since the start of FDIC insurance on January 1. National banks operate in a rapidly changing business environment in which the effectiveness or utility of today's regulations may be eroded by tomorrow's developments in products. the nation's banking system had shut down completely even before President Roosevelt. The OCC uses sparingly the discretion is has under applicable laws to accelerate the effective dates of regulations. Consistent with applicable statutory requirements. More than 9.The heart of the FDIC's mission is to maintain stability and public confidence in the nation's financial system. meetings with representatives of individual banks or with members of trade. These mechanisms may include: a new initiative to assess the effectiveness of regulations in meeting articulated policy goals. has become a symbol of confidence.http://www. The OCC encourages national banks. Federal Deposit Insurance Corporation (FDIC) . services. Among the actions taken by Congress to bring order to the system was the creation of the FDIC in June 1933. posted in insured financial institutions across the country.occ. 000 coverage is generally provided for retirement accounts such as individual retirement accounts (IRAs) and Keoghs. such as single or joint accounts.000 in virtually all United States banks and savings associations (also called savings and loan associations or S&Ls). checking and other deposit accounts. the FDIC is managed by a five-member board of directors appointed by the President and confirmed by the Senate. The FRF. Structure & Funding . Savings. 1980. government. one that is the least-costly to the insurance fund and. The money for these purposes comes from deposit insurance premiums paid by banks and savings associations and from earnings on investments in U. Over time. The FDIC was assigned responsibility for managing the SAIF. which is funded by congressional appropriations. which was created by Congress in 1989 in response to the thrift industry crisis of the 1980s. Promotes the safety and soundness of insured depository institutions and the U. monitoring and addressing risks to the deposit insurance funds. 158 . On March 31.When federal deposit insurance became effective in 1934. may be separately insured. Congress created the SAIF to succeed the Federal Savings and Loan Insurance Corporation (FSLIC) to insure deposits to specified amounts at savings associations and many savings banks. Also. Deposits in most commercial banks and many savings banks are insured by the BIF.S.000 per depositor in each financial institution insured by the FDIC. separate $100. Both the BIF and SAIF deposit insurance programs are backed by the full faith and credit of the U.S. coverage has increased. the least disruptive for customers. when combined.S. The FDIC is subject to audits by the General Accounting Office and oversight by Congress. In 1989.158 Today the FDIC: • • • Insures deposits up to $100. when possible. coverage was raised to its current $100.000 statechartered "nonmember" banks (commercial and savings banks that are not members of the Federal Reserve System). the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF). The FDIC administers two federal deposit insurance funds. Treasury securities. The FDIC also is the primary federal regulator of about 6. The FDIC receives no congressional appropriations to carry out its mission as a deposit insurer and banking regulator.500 per depositor. Insurance Coverage . Arranges a resolution for each failing institution. is responsible for wrapping up the obligations of the former FSLIC and the former Resolution Trust Corporation (RTC). are generally insured up to $100. financial system by identifying. coverage was limited to $2. The FDIC separately manages the FSLIC Resolution Fund (FRF).000 limit. Deposits held in different ownership categories.An independent agency of the federal government. real estate and securities). The FDIC's process for examining and supervising institutions includes on-site examinations and off-site analyses of reports filed by institutions. Examinations are the foundation of the FDIC's efforts to ensure the safety and soundness of institutions. No matter which option the FDIC uses.The FDIC is the primary federal regulator of state nonmember banks and. for insurance purposes. or the Office of Thrift Supervision. mutual funds or similar types of investments that may be offered for sale at FDIC-insured banks and savings and loan associations. and does not include securities. which helps reduce the agency's costs of handling the failed institution. General creditors are paid to the extent possible only after all depositors are paid in full. the Office of the Comptroller of the Currency. but by law it must use the least-costly approach in each case. Proceeds from asset sales are used to reimburse the insurance funds and to pay uninsured depositors. It may be necessary for the FDIC to retain and manage some of the less-desirable assets. Shareholders of the failed institution receive any residual value. The FDIC attempts to return the assets of the failed institution to the private sector as quickly as possible. By maintaining banking services at most or all of the failed institution's offices. When a federally insured bank or S&L fails to protect insured depositors. the FDIC responds immediately.000 insurance limit are always fully protected. such as uninsured depositors (those over the $100. The assuming institution also usually pays a premium to the FDIC." where the FDIC arranges with an existing or newly chartered institution to assume either the insured deposits or all of the deposits (insured and uninsured) of the failed institution. The FDIC uses recoveries from a failed institution's assets for two main purposes: (1) to replenish the insurance fund that protected the failed institution's depositors. Supervision . In rare instances. Institutions generally are closed by their chartering authority the state regulator. the purchaseand-assumption approach is less disruptive to the community than other options available to the FDIC.159 Federal deposit insurance coverage is limited to deposits. 159 . to the extent possible. payments are made directly to insured depositors.000 insurance limit). is the back-up supervisor over the remaining federally insured banks and savings associations. They are used to determine the condition of an institution and to check for compliance with laws and regulations. although there usually is none. and most of the assets are sold to healthy institutions soon after the troubled institution is closed. and (2) to minimize the losses suffered by parties who are not protected by the insurance fund.000 insurance limit and recovering as much money as possible from the failed institution's assets (primarily loans. The option generally used is called a "purchase-andassumption agreement. funds within the $100. The FDIC has several options for resolving failed institutions. when the FDIC is unable to arrange for an assuming institution. The FDIC's job involves paying depositors up to the $100. Customers of the failed institution automatically become customers of the assuming institution. along with all or some of the loans and other assets. including FDIC examiners and financial analysts.Examination procedures that address banks' and savings institutions' use of electronic data processing systems and online banking (sometimes called E-banking). In recent years. the nation faced a financial crisis not paralleled since the Great Depression. Congress enacted the Community Reinvestment Act (CRA) to encourage federally insured banks and thrifts to meet the credit needs of their entire community. 160 . But by the mid-1990s. Compliance . and seeks early remedies. Community Reinvestment Act .The FDIC performs compliance examinations to determine whether the institutions it supervises meet the requirements of various consumer protection. Approximately 2. and conducts several kinds of banking examinations. the FDIC has developed a number of initiatives aimed at identifying and addressing emerging risks to the banking industry and the insurance funds. The CRA encourages banks and thrifts to help meet the credit needs of their communities. The FDIC identifies and monitors such risks to the funds by drawing on a number of sources of information. Information Systems & E-banking . the FDIC looks for poor risk-management or excessive risk-taking by an institution. the health of the banking and thrift industries was dramatically improved. examines financial institutions to ensure they are conducting business in compliance with consumer protection rules and in a way that minimizes risk to their customers and to the deposit insurance funds.160 As part of its examination. The FDIC also aims to reduce the regulatory burden on banks where regulations no longer reduce the risk to the deposit insurance funds or protect consumers. Two examples are the Community Reinvestment Act (CRA) and the Truth in Lending Act. Guidance for officers and employees of banks and savings institutions to assist them in meeting these responsibilities. The Truth in Lending Act requires accurate disclosures of interest rates and finance charges so that loan applicants can comparison-shop for mortgages or consumer loans. Examinations . In the 1980s and early 1990s. other government sources of economic statistics. translating into rapidly declining numbers of failures and problem institutions. Banks and S&Ls were earning record profits.The FDIC. as well as other bank regulatory agencies.In 1977. the FDIC issues regulations governing banks' and savings associations' procedures and performance. in conjunction with other federal and state regulatory agencies.900 banks and savings institutions failed between 1980 and 1993. fair lending and related regulations. By statute. the FDIC examines state nonmember banks to ensure their compliance with equal credit and other consumer protection laws. including low-and moderate-income residents. In addition. and analyses and data from the private sector. 1999 . national banking laws and regulations supersede the laws and regulations in individual states. Examiner Training Program .States have also enacted laws and regulations to govern banking activities." The FDIC promotes compliance with fair lending. The FDIC. very little emphasis is placed on banking regulations in individual states.Descriptions of training programs for federal and state examiners.The Community Affairs Program assists consumer and community groups. financial institutions. The FDIC examines the trust operations of FDIC-regulated financial institutions.A safety and soundness examination is what most people think of when they hear "bank examination.The FDIC's consumer outreach programs and publications address the concerns of depositors and other customers of banks and savings associations. and adherence to certain laws and regulations. (The information above was taken from the Federal Deposit Insurance Corporation Web site on November 6. specific banking laws and regulations differ from state to state. policies and procedures.161 Safety & Soundness . an interagency body empowered to "prescribe uniform principles and standards for the federal examination of financial institutions. It also works with lenders.The FDIC was created by the Banking Act of 1933 and continues to be governed by a variety of laws enacted by Congress. conducted by the Federal Financial Institutions Examination Council (FFIEC). Laws & Regulation . examiners and other interested groups and individuals in understanding and participating in the Community Reinvestment Act. Trust . on-premise FDIC examinations help assess an institution's financial condition. Consumer Affairs Program and Publications . State Regulatory Systems . 161 . Generally.gov/) 4. as a result.Banks and savings institutions may be granted trust (fiduciary) powers under the jurisdiction of Federal Financial Institutions Examination Council (FFIEC) regulatory agencies. In its capacity as court-appointed receiver. government officials. Community Affairs Program . the FDIC liquidates a variety of assets including loans and real estate. Safety and soundness examinations are a vital tool in protecting the financial integrity of the deposit insurance funds and promoting public confidence in the banking system and individual banks. in collaboration with other Federal Financial Institutions Examination Council (FFIEC) regulatory agencies.fdic. organizations and the general public to revitalize and educate communities. Additionally. and other consumer protection laws and regulations.http://www. writes and enforces regulations that govern the way banks and savings institutions do business." These periodic. Community Reinvestment Act. or association. Unlike banks and other financial institutions. 1751 through 1790). It is entirely funded by credit unions and receives no tax dollars. distressed areas and rural neighborhoods. The following section is an excerpt of text of the National credit Union Administration Act. 700. National Credit Union Administration (NCUA) is an independent federal agency that supervises and insures 6.C. a credit union is chartered according to a specific “field of membership. well-operated.http://www. supervising. and well-managed financial institutions. Credit unions believe in “serving the underserved.” (The information above was taken from the State of Illinois. and insuring federal credit unions.S.state. NCUA also insures state credit unions which apply and qualify for insurance. 628. 944. non-profit financial cooperative organized to promote thrift among its members and to make loans to its members from accumulated savings.707 federal credit unions and insures 4. solid. they have expanded their memberships to low-income communities. examining. TITLE 12--BANKS AND BANKING CHAPTER VII--NATIONAL CREDIT UNION ADMINISTRATION Sec.1 Definitions (a) Act means the Federal Credit Union Act (73 Stat.134 state-chartered credit unions.obre. of a regulatory agency in a State is the Illinois Office of Banks and Real Estate. residence. and their information systems in order to assure the safety and soundness of such institutions in compliance with applicable laws and regulations for the benefit of the public.il. The Web site for the Illinois Bureau of Banks and Trust Companies states: “The mission of the Bureau of Banks and Trust Companies is to charter or authorize and supervise state-chartered commercial banks. Office of Banks and Real Estate Web site on December 31. responsible for chartering. NCUA is an independent financial regulatory agency of the federal government. corporate fiduciaries.” In addition to serving employees of large corporations.us/) 5. Anyone who falls within a credit union’s field of membership may join. electronic funds transfer systems. A credit union is a member-owned. Credit unions are the fastest growing of all financial institutions and are rated highest in customer satisfaction. Credit unions range in size from the very small to large and complex world-wide operations.” The field is made up of people who have a “common bond” of occupation. 84 Stat.162 An example. foreign bank offices. 162 . Credit unions are good. Bureau of Banks and Trust Companies. The Bureau’s mission also includes registering check printers and nonfinancial institution deployers of Automated Teller Machines and licensing pawnbrokers that operate in Illinois. 1999 . 12 U. (9) Prepaid expenses. any of the several Territories and possessions of the United States. Collateralized mortgage obligations that are comprised of government guaranteed mortgage loans shall be included in this asset category. the District of Columbia. Part B of the Higher Education Act of 1965 (20 U. which deal exclusively in investments authorized by the Federal Credit Union Act that are either carried at the lower cost or market. its agencies. including mutual funds. as the context permits. (4) Loans to other credit unions that have a remaining maturity of 5 years or less.163 (b) Administration means the National Credit Union Administration. et seq. other than Membership Capital Share Deposit accounts as defined in part 704. (ii) Is designated by the National Credit Union Administration as a corporate credit union. Federal Home Loan Mortgage Corporation. (7) Shares or deposits in a corporate credit union that have a remaining maturity of 5 years or less. (8) Common trust investments. (c) Board means the Board of the National Credit Union Administration. the Federal National Mortgage Association. equal to and maintained to at least the amount of the loan outstanding.S. (h) Remaining maturity is the time period from the date of the required reserve transfer to the stated date of maturity of the instrument. or due from the U. all assets except the following shall be considered risk assets: (1) Cash on hand. or are marked to market value monthly.C.S. and (iii) Limits natural person members to the minimum required by state or federal law to charter and operate the credit union. savings and loan associations. 163 . (5) Student loans insured under the provisions of title IV. (11) Loans fully secured by a pledge of shares in the lending Federal credit union. (i) Is operated primarily for the purpose of serving other credit unions. fully guaranteed as to principal and interest by. (2) Deposits and/or shares in federally or state-insured banks. the Panama Canal Zone. under the laws of any State. (10) Accrued interest on non-risk investments. (6) Loans that have a remaining maturity of 5 years or less and are fully insured or guaranteed by the Federal or a state government or any agency of either. (d) Credit Union means a credit union chartered under the Federal Credit Union Act or. or the Government National Mortgage Association. (g) State means a State of the United States. (f) Regional Office means the office of the Administration located in the designated geographical areas in which the office of the Federal credit union is located.) or similar state insurance programs that have a remaining maturity of 5 years or less. 1071. (3) Assets that have a remaining maturity of 5 years or less and are insured by. and credit unions that have a remaining maturity of 5 years or less. and the Commonwealth of Puerto Rico. (i) For the purpose of establishing the reserves required by section 116 of the Federal Credit Union Act. (12) Loans which are purchased from liquidating credit unions and guaranteed by the National Credit Union Administration. (e) Regional Director means the representative of the Administration in the designated geographical area in which the office of the Federal credit union is located. Government. 6. irrespective of whether or not the asset is being carried on the credit union's records at the lower of cost or market. and (ii) The likelihood of further depreciation of the share-asset ratio is not probable. gross income means the total of the operating income accounts reduced by the following. 725. 4.36(b). 6. (1) Dividends received on shares in the National Credit Union Administration Central Liquidity Facility. Dec. as amended at 37 164 . (2) For purposes of this section. to the extent of interest paid to the Facility by the Agent group representative. and bylaws are met. 1972. 725. and 7 with maturities greater than 5 years are exempt from risk assets if the asset is being carried on the credit union's records at the lower of cost or market. as defined in Sec. and (iii) The return of the share-asset ratio to its normal limits within a reasonable time for the credit union concerned is probable. excluding shares of members and non-members. (15) Assets included in numbered items 2. are considered liabilities. 4. Recorded value will be considered the cash value of any asset account providing accepted accounting principles and practices are followed and the provisions of law. 3. (ii) Liabilities. and 7. 3. and (iv) The probability of a further potential loss to the insurance fund is negligible.164 (13) National Credit Union Share Insurance Fund Guaranty Accounts established with the authorization of the National Credit Union Administration under the authority of section 208(a)(1) of the Federal Credit Union Act. In the case of an Agent member of the Central Liquidity Facility that is a group of central credit unions-(i) Interest received by the Agent group representative. (18) Deposit in the National Credit Union Share Insurance Fund representing a federally insured credit union's capitalization account balance of one percent of insured shares. 701. (14) Investments in shares of the National Credit Union Administration Central Liquidity Facility.1(b) of this chapter. or are being marked to market value monthly. 15. Recorded liabilities which are due and payable. as defined in Sec. (17) Fixed Assets as defined in Sec. Jan. 5. (k) For purposes of determining the amount required to be transferred to regular reserves under sections 116 and 201(b)(6) of the Federal Credit Union Act. (16) Assets included in numbered items 2.7 of this chapter. (2) Dividends received by credit unions on special share accounts held in Agent members of the Central Liquidity Facility authorized by Sec.1(b) of this chapter. with remaining maturities greater than 5 years are exempt from risk assets provided they meet the following criteria. [36 FR 23794. 725. or are being marked to market value monthly. A credit union will be determined to be insolvent when the total amount of its shares exceeds the present cash value of its assets after providing for liabilities unless: (i) It is determined by the Board that the facts that caused the deficient share-asset ratio no longer exist. 1971. 5. (j)(1) Insolvency. regulation. Non-operating gains and losses are not included in gross income. and (3) Interest received by an Agent member of the Central Liquidity Facility to the extent of interest paid to the Facility by the Agent member. the following definitions are used: (i) Cash value of assets. 37 FR 329. 11. and (ii) Interest received by each central credit union in the Agent group (other than the Agent group representative) to the extent of interest paid by each such central credit union to the Agent group representative on Agent group representative loans. 1990. right of rescission.Bank Holding Company Act Reg Z . July 27.Availability of Funds and Collection of Checks Reg DD . 54 FR 48234. 1993] (The information above was taken from the Code of Federal Regulations Web site on December 5.Collection of Checks and other Items Reg K . 45 FR 47121. May 20. Some of the laws and regulations that govern banking are listed below. 54 FR 52015.Community Reinvestment Act Reg CC . 1992.Loans to Executive Officers Reg P/Reg 21.access.Real Estate Lending and Appraisals Bank Bribery Act Bank Secrecy Act Fair Credit Reporting Act Fair Debt Collection Practices Act Fair Housing Act Financial Institution Reform. 57 FR 47985. 22.Depository Institution Man.165 FR 10342.html#700) B.gpo.Edge Act Reg L .Home Mortgage Disclosure Act Reg D . 58 FR 40042. Nov.http://www. 19.Interest on Deposits Reg U . Jan. Laws and Regulations Legislation has been enacted to serve the interests of consumers and the entities involved in commercial banking activities. closed end. restitution) Reg BB . • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • Reg A . 1980.gov/nara/cfr/waisidx_98/12cfrv6_98. 1989. 1999 .Truth in Lending (open end. home equity. Interlocks Act Reg M . July 14. Oct. 55 FR 1794.Credit by Banks for Purchase of Margin Stocks Reg Y .Electronic Funds Transfer Act Reg J .Bank Protection Act Reg Q . 1989.Borrowing by Depository Institutions Reg B .Equal Credit Opportunity Act Reg C . 21. Recovery and Enforcement Act (FIRREA) FDIC Bank Improvement Act of 1991 Foreign Corrupt Practices Act National Flood Insurance Program OFAC Real Estate Settlement Procedures Act 165 .Reserve Requirements Reg E . credit cards. Dec. 20.Consumer Leasing Reg O .Truth in Savings Reg 34 . 1972. and 461).http://www. This part establishes rules under which Federal Reserve Banks may extend credit to depository institutions and others. 28. Dec. 374. Regulation A – Borrowing by Depository Institutions .C.S. 347b. Entities such as corporations. Banks or other depository institutions may participate in the following lending programs: • • • An adjustment credit is available to help institutions meet short-term obligations when the normal source of funds is not available. partnerships. portions of the legislation have been bolded by the authors to highlight key information. (b) Purpose. 13.gpo. scope and purpose (a) Authority and scope. the lending function of the Federal Reserve Banks is an effective method of supplying reserves to meet the particular credit needs of individual depository institutions. An extended credit is available to help institutions meet long-term needs. Extending credit to depository institutions to accommodate commerce.S.12 CFR Part 9 Following will be a brief discussion of each of these regulations. The following section is an excerpt of text of Regulation A TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. In most cases. This part is issued under the authority of sections 10A. and individuals can obtain emergency credit. and section 7(b) of the International Banking Act of 1978 (12 U. 10B. While open market operations are the primary means of affecting the overall supply of reserves. [58 FR 68512. 374a.C. 343 et seq. and 19 of the FRA (12 U. The lending functions of the Federal Reserve System are conducted with due regard to the basic objectives of monetary policy and the maintenance of a sound and orderly financial system. 348 et seq.166 • • • • Right to Financial Privacy Act Tax Identification Reporting (TIN Compliance) Transactions with Affiliates . 1. 347d) and relates to extensions of credit by Federal Reserve Banks to depository institutions and others.. 201.gov/nara/cfr/waisidx/12cfrv2. 347c. industry.html) 166 . An emergency credit is available to help non-depository institutions to obtain credit to limit adverse impact on the economy. and agriculture is a principal function of Federal Reserve Banks. 1993] (The information above was taken from the Code of federal Regulations Web site on December 4. 13A. other provisions of the FRA. 347a. In some cases.governs borrowing at the Federal Reserve discount window..1 Authority. the actual text of the legislation will be included to supplement the brief summary.access.FRB Sections 23 A&B Trust . 1999 . or age. Dec. 50 FR 48026.C. 16.gpo. Creditors are prohibited from discriminating on non-financial factors such as race. Regulation C – Home Mortgage Disclosure Act . as defined in Sec. Information collection requirements contained in this regulation have been approved by the Office of Management and Budget under the provisions of 44 U.provide the public with loan data that can be used to: • • To help determine whether financial institutions are serving the housing needs of their communities. Nov. 202. 3501 et seq. national origin. color. marital status.http://www. to retain records of credit applications. color. to report credit history in the names of both spouses on an account. [Reg. religion. Additionally. banks are required to provide applicants with a notice of action regarding the loan application and collect monitoring information regarding an applicant’s race. The purpose of this regulation is to promote the availability of credit to all creditworthy applicants without regard to race. Regulation B – Equal Credit Opportunity Act . as amended (15 U. The regulation prohibits creditor practices that discriminate on the basis of any of these factors. To assist public officials in distributing public-sector investments so as to attract private investment to areas where it is needed. national origin. sex. 1601 et seq.2(1). and have been assigned OMB control number 7100-0201. The following section is an excerpt of text of Regulation B. 1985. to collect information about the applicant's race and other personal characteristics in applications for certain dwelling-related loans. marital status. This regulation is issued by the Board of Governors of the Federal Reserve System pursuant to title VII (Equal Credit Opportunity Act) of the Consumer Credit Protection Act. sex.1 Authority.167 2. 20. or age (provided the applicant has the capacity to contract).). TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec.html) 3. marital status. The regulation also requires creditors to notify applicants of action taken on their applications. 202. religion. religion. and to provide applicants with copies of appraisal reports used in connection with credit transactions. color.promotes the availability of credit to all credit-worthy applicants.S. and age. the regulation applies to all persons who are creditors. as amended at 58 FR 65661.access. to the fact that all or part of the applicant's income derives from a public assistance program. and 167 . sex.C. scope and purpose. (b) Purpose. national origin. 1999 .gov/nara/cfr/waisidx/12cfrv2. 1993] (The information above was taken from the Code of federal Regulations Web site on December 4.S. B. or to the fact that the applicant has in good faith exercised any right under the Consumer Credit Protection Act. Except as otherwise provided herein. (a) Authority and scope. It requires an institution to report data to its supervisory agency about home purchase and home improvement loans it originates or purchases. 3064-0046. (a) Authority. as amended at 63 FR 52142. C.S.S. The disclosure statements and reports will be available to the public at central data depositories located in each MSA. numbers for the National Credit Union Administration and the Department of Housing and Urban Development are pending. the Office of Thrift Supervision. (1) This regulation implements the Home Mortgage Disclosure Act. 15. DC 20006. and 7100-0247 for institutions reporting data to the Office of the Comptroller of the Currency. respectively. and other mortgage lending institutions. 3501 et seq. (ii) To assist public officials in distributing public-sector investments so as to attract private investment to areas where it is needed. as amended. Using the loan data made available by financial institutions. (b) Purpose. credit unions.168 • To assist in identifying possible discriminatory lending patterns and enforcing antidiscrimination statutes. 30.2(e). Office of Management and Budget under 44 U. the Federal Financial Institutions Examination Council will prepare disclosure statements and will produce various reports for individual institutions for each metropolitan statistical area (MSA). (2) Neither the act nor this regulation is intended to encourage unsound lending practices or the allocation of credit. The following section is an excerpt of text of Regulation C. 1550-0021.S. showing lending patterns by location. [Reg. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. or for which it receives applications. and the Federal Reserve System. sex.C. saving associations. and (iii) To assist in identifying possible discriminatory lending patterns and enforcing antidiscrimination statutes. income level. 203. and to disclose certain data to the public. 1998] 168 .). A listing of central data depositories can be obtained from the Federal Financial Institutions Examination Council. and scope. This regulation is issued by the Board of Governors of the Federal Reserve System (``Board'') pursuant to the Home Mortgage Disclosure Act (12 U. 54 FR 51362. 2801 et seq. 1989. and have been assigned OMB Numbers 1557-0159. purpose. (c) Scope. (d) Loan aggregation and central data depositories. Sept. This regulation applies to certain financial institutions.C. including banks. which is intended to provide the public with loan data that can be used: (i) To help determine whether financial institutions are serving the housing needs of their communities. Dec. The information-collection requirements have been approved by the U. the Federal Deposit Insurance Corporation. as defined in Sec. age of housing stock. and racial characteristics.1 Authority. Washington. 203. (c) Scope. a foreign bank's branch or agency located in the United States is required to comply with the provisions of this part in the same manner and to the same extent as if the branch or agency were a member bank.C.gov/nara/cfr/waisidx/12cfrv2. 1813(f).C.C. 1999 . or (ii) is controlled by a foreign company or by a group of foreign companies that own or control foreign banks that in the aggregate have total worldwide consolidated bank assets in excess of $1 billion.C. 1781). 1724(a)) or any institution which is eligible to apply to become an insured institution under section 403 of such Act (12 U.html) 4. This part is issued under the authority of section 19 (12 U. (b) Purpose. 204.S. 461 et seq. (iii) Any insured credit union as defined in section 101 of the Federal Credit Union Act (12 U.C.S. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec.S. purpose and scope. Regulation D – Reserve Requirements . 1752(7)) or any credit union that is eligible to apply to become an insured credit union under section 201 of such Act (12 U.C.access. any other foreign bank's branch located in the United States that is eligible to apply to become an insured bank under section 5 of the Federal Deposit Insurance Act (12 U. 1815). This part relates to reserves that depository institutions are required to maintain for the purpose of facilitating the implementation of monetary policy by the Federal Reserve System. (ii) Any savings bank or mutual savings bank as defined in section 3 of the Federal Deposit Insurance Act (12 U.S. 1422(4)).C.C.) and other provisions of the Federal Reserve Act and of section 7 of the International Banking Act of 1978 (12 U. 1815) is required to maintain reserves in accordance with this part as a nonmember depository institution.http://www. if its parent foreign bank (i) has total worldwide consolidated bank assets in excess of $1 billion.1 Authority.relates to reserves that depository institutions are required to maintain for the purpose of facilitating the implementation of monetary policy by the Federal Reserve System. (g)). 1726).C.C. 3105).C.gpo.S. 1813(h)) or any bank that is eligible to apply to become an insured bank under section 5 of such Act (12 U.S.169 (The information above was taken from the Code of federal Regulations Web site on December 4. Depository institutions must maintain reserves in the form of vault cash or have an adequate balance at a Federal Reserve or corresponding bank. (iv) Any member as defined in section 2 of the Federal Home Loan Bank Act (12 U. and (v) Any insured institution as defined in section 401 of the National Housing Act (12 U. The following section is an excerpt of text of Regulation D. (1) The following depository institutions are required to maintain reserves in accordance with this part: (i) Any insured bank as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.S. In addition.S. (2) Except as may be otherwise provided by the Board.S. (a) Authority.S. 169 . ) is required to comply with the provisions of this part in the same manner and to the same extent as a member bank. This part carries out the purposes of the Electronic Fund Transfer Act. The regulation in this part. (ii) is owned primarily by the financial institutions with which it does business. (4) This part does not apply to any financial institution that (i) is organized solely to do business with other financial institutions. (The information above was taken from the Code of federal Regulations Web site on December 4. 7100-0200.html) 5. 601 et seq.C. and responsibilities of consumers and banks involved in electronic funds transfers. Aug. It became a law in 1978 and establishes the basic rights. liabilities. which establishes the basic rights. and have been assigned OMB No. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. The primary objective of the act and this part is the protection of individual consumers engaging in electronic fund transfers.html) 6.C. liabilities.gpo.gov/nara/cfr/waisidx/12cfrv2. and (iii) does not do business with the general public. 3501 et seq. [45 FR 56018.access.170 (3) Except as may be otherwise provided by the Board.http://www.http://www. (5) The provisions of this part do not apply to any deposit that is payable only at an office located outside the United States. 1999 . 611 et seq.S.C.). The information-collection requirements have been approved by the Office of Management and Budget under 44 U. known as Regulation E. 205.1 Authority and purpose (a) Authority. (b) Purpose.C. and responsibilities of consumers who use electronic fund transfer services and of financial institutions that offer these services.gpo.gov/nara/cfr/waisidx/12cfrv2.access.) or an Agreement Corporation (12 U. 1999 . TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. 210. 1980] (The information above was taken from the Code of federal Regulations Web site on December 4. Regulation E – Electronic Funds Transfer Act – purpose is to protect consumers engaging in electronic funds transfers. and scope.S. is issued by the Board of Governors of the Federal Reserve System pursuant to the Electronic Fund Transfer Act (15 U.1 Authority. The following section is an excerpt of text of Regulation J. purpose. 1693 et seq. The following section is an excerpt of text of Regulation E. Regulation J – Collection of Checks and Other Items – purpose is to provide rules for collecting and returning items and settling balances. 22.S. an Edge Corporation (12 U. 170 .S. and section 19(f) (12 U. Oct. this subpart and the operating circulars of the Reserve Banks apply to the following when acting as a sender: a department. Reg. provide for instructions by an Administrative Reserve Bank to other Reserve Banks. (a) General. 342). This subpart. 1988.171 The Board of Governors of the Federal Reserve System (Board) has issued this subpart pursuant to the Federal Reserve Act. Each Reserve Bank shall receive and handle items in accordance with this subpart. as amended at 51 FR 21744. This subpart governs the collection of checks and other cash and noncash items and the handling of returned checks by Federal Reserve Banks.C. June 13. as amended at Reg. To the extent provided by regulations issued by. 62 FR 48171. 210.C. 248(o) and 360). among other things. (f) Relation to other law. The handling of such items in a state is governed by this subpart. Except as otherwise provided by statutes of the United States. [53 FR 21984. 15. The provisions of this subpart supersede any inconsistent provisions of the Uniform Commercial Code. May 4. 16. and arrangements made with. and payment of interest by as-of adjustment. set forth terms of services.S.). 1986. 464). waiver of expenses. J. Its purpose is to provide rules for collecting and returning items and settling balances. (b) Binding effect. 1994. section 13 (12 U. 53 FR 21984. The Reserve Banks shall include in their operating circulars such information regarding these regulations and arrangements as the Reserve Banks deem appropriate. require separate sorts and letters.S. agency.C. J. 1997] 171 . or regulations issued or arrangements made thereunder. (e) Foreign items. but only to the extent of the inconsistency. The circulars may. of any other state law.C. June 13. section 16 (12 U. or office of the United States. (c) Government items.S. and shall issue operating circulars governing the details of its handling of items and other matters deemed appropriate by the Reserve Bank. (d) Government senders. classify cash items and noncash items. the Expedited Funds Availability Act (12 U.S. provide different closing times for the receipt of different classes or types of items. As depositaries and fiscal agents of the United States. are binding on all parties interested in an item handled by any Reserve Bank. Sept. 1988. independent establishment. including amounts. or of part 229 of this title. A Reserve Bank also may receive and handle certain items payable outside a Federal Reserve District. June 16. 59 FR 22965. the handling of such items is governed by this subpart. together with subpart C of part 229 and the operating circulars of the Reserve Banks.S. Reserve Banks handle certain items payable by the United States or certain Federal agencies as cash or noncash items. as provided in its operating circulars. instrumentality. the United States Treasury Department and other Government departments and agencies. 248 (i) and (j)). 1980. 59 FR 22965. 1994] Sec. 4001 et seq. or a wholly owned or controlled Government corporation.3 General provisions. May 4.C. [45 FR 68634. that maintains or uses an account with a Reserve Bank. and other laws. sections 11 (i) and (j) (12 U. and establish procedures for adjustments on a Reserve Bank's books. and the handling of such items outside a state is governed by the local law. C. banking organizations.). 601-604a). This subpart applies to: (1) Corporations organized under section 25(a) of the FRA (12 U.gpo. Regulation K – Edge Act – purpose is to provide rules governing the international and foreign activities of U.gov/nara/cfr/waisidx/12cfrv2. The following section is an excerpt of text of Regulation K. et seq.). Apr.172 (The information above was taken from the Code of federal Regulations Web site on December 4. 611-631). 321). and have been assigned OMB numbers 7100-0107.access. 7100-0086.C. 221 et seq.] (The information above was taken from the Code of federal Regulations Web site on December 4. and scope. and 7100-0073.S.gov/nara/cfr/waisidx/12cfrv2.S. including procedures for establishing foreign branches and Edge corporations to engage in international banking and for investments in foreign organizations. purpose.C. 211. 7100-0109. Regulation L – Interlocks Act – was designed to foster competition in the banking industry by limiting the sharing of banking personnel.S.C. 3501. 7100-0069. which refers to national banking associations.\1\ and \1\ Section 25 of the FRA.S. including procedures for establishing foreign branches and Edge corporations to engage in international banking and for investments in foreign organizations. This subpart sets out rules governing the international and foreign activities of U. ``Agreement corporations''.S. (a) Authority.1 Authority. 3101 et seq. 601-604a).C. 1843(c)(13)). 1999 . This subpart is issued by the Board of Governors of the Federal Reserve System (``Board'') under the authority of the Federal Reserve Act (``FRA'') (12 U. (b) Purpose. unless otherwise noted. 29.html) 7.gpo.). banking organizations.S. For example. and the International Banking Act of 1978 (``IBA'') (12 U. the Bank Holding Company Act of 1956 (``BHC Act'') (12 U.html) 8.C. Requirements for the collection of information contained in this regulation have been approved by the Office of Management and Budget under the provision of 44 U. also applies to state member banks of the Federal Reserve System by virtue of section 9 of the FRA (12 U. [56 FR 19565. 1999 . (2) Corporations having an agreement or undertaking with the Board under section 25 of the FRA (12 U.access. The Edge Act was first enacted in 1919 and Regulation K was promulgated in 1979. ``Edge corporations''.S.C.S.http://www.S.C. (c) Scope. 7100-0110. 1841 et seq. (4) Bank holding companies with respect to the exemption from the nonbanking prohibitions of the BHC Act afforded by section 4(c)(13) of the BHC Act (12 U.C.http://www.S. a management official can’t 172 . TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. 1991.S. (3) Member banks with respect to their foreign branches and investments in foreign banks under section 25 of the FRA (12 U. insured by the Federal Deposit Insurance Corporation and chartered under State law. As used in this title-(1) the term "depository institution" means a commercial bank. as the term "subsidiary" is defined in either section 2(d) of the Bank Holding Company Act of 1956 in the case of a bank holding company or section 408(a)(1)(H) of the National Housing Act in the case of a savings and loan holding company. a savings bank. chartered under State law and insured by the Federal Deposit Insurance Corporation. or both corporations are subsidiaries of the same depository holding company. or (B) more than 25 percent of the voting stock of one corporation is beneficially owned in the aggregate by one or more persons who also beneficially own in the aggregate more than 25 percent of the voting stock of the other corporation. and the other corporation is a mutual savings bank. except for directors qualifying shares. director. a savings and loan association. (4) the term "management official" means an employee or officer with management functions. except in the case of a depository institution with total assets of less than $100. trustee. and is a bankers' bank. (3) the characterization of any corporation (including depository institutions and depository holding companies). a trust company. or {{10-31-94 p. or (C) one of the corporations is a trust company all of the stock of which. a company which would be a bank holding company as defined in section 2(a) of the Bank Holding Company Act of 1956 but for the exemption contained in section 2(a)(5)(F) thereof. as an "affiliate of. as permitted by State law. 202. That in no case shall the voting securities of such corporation be held by such officers of other banks in excess of 6 per centum of the paid-in capital and 6 per centum of the surplus of such a bank. The following section is an excerpt of text of Regulation L. 173 . the voting securities of which are held only by persons who are officers of other banks. however. (2) the term "depository holding company" means a bank holding company as defined in section 2(a) of the Bank Holding Company Act of 1956.8592}} (D) one of the corporations is a bank. a building and loan association. and which bank is primarily engaged in providing banking services for other banks and not for the public: Provided. a trustee of a business organization under the control of trustees. described in Paragraph Seventh of section 5136 of the Revised Statutes. or other officer of a State-chartered trust company which does not make real estate mortgage loans and does not accept savings deposits from natural persons." or as "affiliated" with any other corporation means that-(A) one of the corporations is a depository holding company and the other is a subsidiary thereof.000. then. a homestead association. SEC. a director (including an advisory or honorary director. or a savings and loan holding company as defined in section 408(a)(1)(D) of the National Housing Act. or other officer of a State-chartered savings bank or cooperative bank is specifically authorized under the laws of the State in which said institution is located to serve as a trustee. was owned by one or more mutual savings banks on the date of enactment of this Act.000). a cooperative bank. or a credit union. or any person who has a representative or nominee serving in any such capacity: Provided. That if a corporator. for the purposes of this title. or (E) one of the corporations is a bank. an industrial bank.173 serve in a management capacity of two institutions in the same community. director. 000. That if a management official of a State-chartered trust company which does not make real estate mortgages loans and does not accept savings deposits from natural persons is specifically authorized under the laws of the State in which said institution is located to serve as a corporator. effective November 10. and 5(b)(1) of the Act of November 10. No.174 such corporator. effective March 10. director. L. 1978 (Pub.500. L. such management official shall not be deemed to be a management official of any such savings bank or cooperative bank. L.000 or as a management official of any affiliate of such other institution. [Codified to 12 U. 3. 92 Stat. or other officer shall not be deemed to be a management official of such trust company: And provided further. trustee. 1979. trustee. L. 103-325.C. 1267). effective September 23. 1983] {{430-97 p. or village contiguous or adjacent thereto.000. No.C. except in the case of depository institutions with less than $20. 1988. for the purposes of this title. town. 108 Stat. 3673). 92 Stat. 100--650.000 in assets in which case the provision of paragraph (2) shall apply. then. 95--630. or (2) the same city.8593}} SEC.S. the same metropolitan statistical area. No. as that in which an office of the other institution or any depository institution that is an affiliate of such other institution is located. [Codified to 12 U. 203. effective March 10. 95--630. 204. 3202] [Source: Section 203 of title II of the Act of November 10.000. 102 Stat. 2227). 1979. L. A management official of a depository institution or a depository holding company may not serve as a management official of any other depository institution or depository holding company not affiliated therewith if an office of one of the institutions or any depository institution that is an affiliate of such institutions is located within either-(1) the same primary metropolitan statistical area. as amended by sections 2. 97 Stat.S. 1994] SEC. or other officer of a State-chartered savings bank or cooperative bank. In order to allow for inflation or 174 . effective November 30. No. or the same consolidated metropolitan statistical area that is not comprised of designated primary metropolitan statistical areas as defined by the Office of Management and Budget. a management official of such institution or any affiliate thereof may not serve as a management official of any other nonaffiliated depository institution or depository holding company having total assets exceeding $1. If a depository institution or a depository holding company has total assets exceeding $2. 98--181. (Pub.000. or in any city. town. director. 3672). 3819 and 3820).500. 3201] [Source: Section 202 of title II of the Act of November 10. as amended by section 701(c) of title VII of the Act of November 30. No. or village as that in which an office of the other institution or any depository institution that is an affiliate of such other institution is located. section 322(c)(2) of title III of the Act of September 23. 1978 (Pub. and (5) the term "office" used with reference to a depository institution means either a principal office or a branch. 1988. 1994 (Pub. 1983 (Pub. or other official exercising a similar function. as amended by section 2210(a) of title II of the Act of September 30.C. (8)(A) A diversified savings and loan holding company (as defined in section 408(a)(1)(F) of the National Housing Act) with respect to the service of a director of such company who is also a director of any nonaffiliated depository institution or depository holding company (including a savings and loan holding company) if-(i) notice of the proposed dual service is given by such diversified savings and loan holding company to-(I) the appropriate Federal depository institutions regulatory agency for such company. 175 . not less than 60 days before such dual service is proposed to begin. conservator. 1978 (Pub. 1979. The prohibitions contained in sections 203 and 204 shall not apply in the case of any one or more of the following or subsidiary thereof: (1) A depository institution or depository holding company which has been placed formally in liquidation. as necessary. 3203] [Source: Section 204 of title II of the Act of November 10. American Samoa. any territory of the United States. or which is in the hands of a receiver. and (ii) the proposed dual service is not disapproved by any such appropriate Federal depository institutions regulatory agency before the end of such 60-day period. No. or the Virgin Islands except as an incident to its activities outside the United States.S. L. 95--630. 3009--409). 1996 (Pub. [Codified to 12 U. Guam. effective March 10. No. Puerto Rico. and (II) the appropriate Federal depository institutions regulatory agency for the nonaffiliated depository institution or depository holding company of which such person is also a director. (6) A Federal Home Loan Bank or any other bank organized specifically to serve depository institutions. 205. (5) A State-chartered savings and loan guaranty corporation. 3673). effective September 30. 104--208. (7) A depository institution or a depository holding company which-(A) is closed or is in danger of closing. 1996] SEC. by regulation. L. the appropriate Federal depository institutions regulatory agencies may. and (B) is acquired by another depository institution or depository holding company. the amount of total assets required for depository institutions or depository holding companies under this section. (2) A corporation operating under section 25 or 25(a) of the Federal Reserve Act. (3) A credit union being served by a management official of another credit union. 110 Stat. during the 5-year period beginning on the date of the acquisition of the depository institution or depository holding company described in subparagraph (A). as determined by the appropriate Federal depository institutions regulatory agency in accordance with regulations prescribed by such agency. (4) A depository institution or depository holding company which does not do business within any State of the United States.175 market changes. the District of Columbia. adjust. 92 Stat. • To limit the amount of balloon payments in consumer lease transactions. 410). 1988 (Pub. 3673). 1999 . at any time after the end of the 60-day period referred to in subparagraph (A). as amended by section 425(d) of title IV of the Act of October 15.{{4-30-97 p. L. L. [Codified to 12 U. (C) Any appropriate Federal depository institutions regulatory agency may. (9) Any savings association (as defined in section 10(a)(1)(A) of the Home Owners' Loan Act or any savings and loan holding company (as defined in section 10(a)(1)(D) of such Act) which has issued stock in connection with a qualified stock issuance pursuant to section 10(q) of such Act. (ii) the dual service would lead to substantial conflicts of interest or unsafe or unsound practices.html. 92 Stat. by a single management official of the savings and loan holding company which purchased the stock issued in connection with such qualified stock issuance. 1979. and shall apply only when the Director of the Office of Thrift Supervision has determined that such service is consistent with the purposes of this Act and the Home Owners' Loan Act.C. 103 Stat. or refused to furnish all the information required by such agency. failed. The purpose of this part is: • To ensure that lessees of personal property receive meaningful disclosures that enable them to compare lease terms with other leases and. 95--630. section 604(a) of title VI of the Act of August 9. 1982.8594}} (i) the dual service cannot be structured or limited so as to preclude the dual service's resulting in a monopoly or substantial lessening of competition in financial services in any part of the United States.) Use this generic site 9. effective August 9.gov/regulations/laws/rules/10000-3. 3819). with credit transactions. under subparagraph (A)(ii). 1524). 1978 (Pub. 102 Stat. 1988. sections 4 and 5(a) of the Act of November 10.fdic. L. No. require that any dual service by any individual which was not disapproved by such agency during such period be terminated if a change in circumstances occurs with respect to any depository institution or depository holding company of which such individual is a director that would have provided a basis for disapproval of the dual service during such period.http://www. 1989] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 31. except that this paragraph shall apply only with respect to service as a single management official of such savings association or holding company. 101-73. a notice of proposed dual service by any individual if such agency finds that-. effective October 15. or (iii) the diversified savings and loan holding company has neglected. 97--320. 1982 (Pub. No. 100--650. 1989 (Pub.S. effective November 10. 96 Stat.176 (B) Any appropriate Federal depository institutions regulatory agency may disapprove. No. or any subsidiary of such savings association or holding company. effective March 10. 3204] [Source: Section 205 of title II of the Act of November 10. Regulation M – Consumer Leasing – Implements the consumer leasing provisions of the Truth in Lending Act. where appropriate. No. L. and 176 . 1996. and 375b). a bank holding company of which the member bank is a subsidiary. 1999 . TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. 213. Section 108 of the act contains the administrative enforcement provisions. 130. The following section is an excerpt of text of Regulation M.S. where appropriate. and enforcement. 131.177 • To provide for the accurate disclosure of lease terms in advertising. which is Title I of the Consumer Credit Protection Act.gpo. Oct. 1. as amended at 62 FR 15367.). 213. scope. 22(g). The purpose is to limit the opportunity for preferential treatment to “insiders.S. Information collection requirements contained in this regulation have been approved by the Office of Management and Budget under the provisions of 44 U. known as Regulation M. 248(i). Sections 112. 215. (a) Authority. is issued by the Board of Governors of the Federal Reserve System to implement the consumer leasing provisions of the Truth in Lending Act. This subpart is issued pursuant to sections 11(i). and section 306 177 .C. (2) To limit the amount of balloon payments in consumer lease transactions. 7. This part applies to all persons that are lessors of personal property under consumer leases as those terms are defined in Sec.S. (c) Enforcement and liability. and (3) To provide for the accurate disclosure of lease terms in advertising.C.http://www. The regulation in this part.C.1 Authority. as amended (15 U. (a) Authority. with credit transactions. and scope. Regulation O – Loans to Executive Officer – purpose is to govern any extension of credit by a member bank to an executive officer.C. or principal shareholder of the member bank. purpose.html) 10. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec.2(e)(1) and (h). (b) Scope and purpose. It was created to control insider lending where an officer would receive preferential treatment and favorable loan terms. The purpose of this part is: (1) To ensure that lessees of personal property receive meaningful disclosures that enable them to compare lease terms with other leases and. M. 1997] (The information above was taken from the Code of federal Regulations Web site on December 21. and have been assigned OMB control number 71000202.access. [Reg.S.gov/nara/cfr/waisidx/12cfr213_99. 375a.” The following section is an excerpt of text of Regulation O. Apr. director. and any other subsidiary of that bank holding company. purpose. 1817(k).1 Authority. and 185 of the act contain the liability provisions for failing to comply with the requirements of the act and this part. 12 U. 61 FR 52258. 1601 et seq. 3501 et seq. and 22(h) of the Federal Reserve Act (12 U. unless otherwise noted. 2236 (1991)). 82 Stat. effective July 7. 105 Stat. In addition it made banks accountable for their enforcement actions and forced banks to maintain appropriate documentation to demonstrate compliance to regulatory agencies. and larcenies at banks. BANK PROTECTION ACT OF 1968 To provide security measures for banks and other financial institutions.access.C. director. 375a concerning extensions of credit by a member bank to its executive officers and of 12 U. 24. 294). L. [Codified to 12 U.gpo.html) 11. Regulation P – Bank Protection Act – purpose is to provide security measures for banks and other financial institutions. and any other subsidiary of that bank holding company.C. 90--389. O. 102-242.S. 1968] SEC. No. and to provide for the appointment of the Federal Savings and Loan Insurance Corporation as receiver. 1881 note] [Source: Section 1 of the Act of July 7. 59 FR 8837. [Reg. 178 .http://www. (b) Purpose and scope. robberies. Second. 1968 (Pub. a bank holding company of which the member bank is a subsidiary.C. (2) The Board of Governors of the Federal Reserve System with respect to Federal Reserve banks and State banks which are members of the Federal Reserve System.S. L.S. 1817(k) concerning extensions of credit by a member bank to its executive officers or principal shareholders. There are two primary reasons for this act. and to provide for the appointment of the Federal Savings and Loan Insurance Corporation as receiver. First. The following section is an excerpt of text of Regulation P. or principal shareholder of: The member bank.] (The information above was taken from the Code of federal Regulations Web site on December 4. 1998 the provisions of Regulation P have been incorporated into Regulation H. 1994. Feb. That this Act may be cited as the "Bank Protection Act of 1968". 2. As used in this Act the term "Federal supervisory agency" means-(1) The Comptroller of the Currency with respect to national banks and district banks. Note: As of October 1. This subpart A also implements the reporting requirements of 12 U. or the related interests of such persons. it promoted the design of procedures assists banks in the identification and apprehension of persons who commit illegal acts. It also applies to any extension of credit by a member bank to: A company controlled by such a person.gov/nara/cfr/waisidx/12cfrv2. and a political or campaign committee that benefits or is controlled by such a person. it established minimum standards of security devices to prevent burglaries. Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled. 1999 . This subpart A governs any extension of credit by a member bank to an executive officer.178 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (Pub. [Codified to 12 U. L. [Codified to 12 U. 90--389. [Codified to 12 U. effective August 9. 1881] [Source: Section 2 of the Act of July 7. 439). A bank or savings and loan association which violates a rule promulgated pursuant to this Act shall be subject to a civil penalty which shall not exceed $100 for each day of the violation. The Federal supervisory agencies shall report to the Congress the results of their consultations pursuant to this section not later than two years after the date of enactment of this Act. 90--389. as amended by section 911(a) of title IX of the Act of August 9. 3. No. 1968] {{8-30-96 p. 295). 1883] [Source: Section 4 of the Act of July 7. L. 295). effective July 7. 1989] SEC. No. 1968 (Pub. burglaries. to discourage robberies. 5. maintenance. 90--389.S. and larcenies committed against financial institutions referred to in section 2.S. No. 103 Stat.8074}} SEC. 1968. effective August 9. as amended by section 744(h) of title VII of the Act of August 9. and (2) State agencies having supervisory or regulatory responsibilities with respect to such insurers to determine the feasibility and desirability of premium rate differentials based on the installation. 101--73. 82 Stat. 1968.C. The Federal supervisory agencies shall consult with (1) insurers furnishing insurance protection against losses resulting from robberies. each Federal supervisory agency shall promulgate rules establishing minimum standards with which each bank or savings and loan association must comply with respect to the installation. No. and larcenies and to assist in the identification and apprehension of persons who commit such acts. 1882] [Source: Section 3 of the Act of July 7. 294) effective July 7. (b) The rules shall establish the time limits within which banks and savings and loan associations shall comply with the standards. 82 Stat. and operation of security devices and procedures. 478). (a) Within six months from the date of this Act.179 (3) The Federal Deposit Insurance Corporation with respect to State banks which are not members of the Federal Reserve System but the deposits of which are insured by the Federal Deposit Insurance Corporation and State savings associations. 101--73. 4. No. L. 1989] SEC. 1968 (Pub. and (4) The Director of the Office of Thrift Supervision with respect to Federal savings. 82 Stat.C. L.C. 1989 (Pub. 179 . 1989 (Pub. burglaries. L. reasonable in cost. 103 Stat. maintenance. and operation of security devices and procedures. 1968 (Pub.S. effective July 7. but are not limited to: (i) Retaining a record of any robbery. at a minimum.2 Designation of security officer.F. 1991. the following security devices: (1) A means of protecting cash or other liquid assets. No. operating and maintaining appropriate security devices.S. (2) Establish procedures that will assist in identifying persons committing crimes against the bank and that will preserve evidence that may aid in their identification and prosecution.0--326. § 326. to develop. or larceny committed against the bank. as specified in paragraph (b) of this section. 90--389. within a reasonable time.4. April 3. the board of directors of each insured nonmember bank{2} {2 The term "board of directors" includes the managing official of an insured branch of a foreign bank for purposes of 12 CFR 326. effective May 3. and similar valuables at all times. and (4) Provide for selecting. Each insured nonmember bank shall have. 180 . 13581.3 Security program. burglary. (ii) Maintaining a camera that records activity in the banking office. burglar or larceny. safe. or other secure space. Reg.2] [Section 326. but no later than 180 days. 1991] § 326.180 [Codified to 12 U. 17917. 1988. 1884] [Source: Section 5 of the Act of July 7. (b) Security devices. 295). 1968] § 326. and to administer a written security program for each banking office. negotiable securities. Upon the issuance of federal deposit insurance. effective July 7.R. such procedures may include. (3) Provide for initial and periodic training of officers and employees in their responsibilities under the security program and in proper employee conduct during and after a robbery. such as prerecorded serial-numbered bills. 82 Stat.C. The security program shall: (1) Establish procedures for opening and closing for business and for the safekeeping of all currency.} shall designate a security officer who shall have the authority. Reg. such as a vault.2 amended at 53 Fed. [Codified to 12 C. 1968 (Pub. subject to the approval of the board of directors. 56 Fed. or chemical and electronic devices. and (iii) Using identification devices. testing. L. May 19. (a) Contents of security program. 4] [Section 326. April 3. and effectiveness of the security program. a bank is expected to provide all advertised services and rates. (iv) The cost of the security devices. (v) Other security measures in effect at the banking office. May 19. taking into consideration: (i) The incidence of crimes against financial institutions in the area. effective May 3. (iii) The distance of the banking office from the nearest responsible law enforcement officers. {{4-30-98 p. [Codified to 12 C. (4) Tamper-resistant locks on exterior doors and exterior windows that may be opened. Regulation Q – Interest on Deposits . TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. the area around the vault.F. and (5) Such other devices as the security officer determines to be appropriate.3 amended at 56 Fed.4 Reports. 1988. § 326. burglary. 13581. It also set guidelines regarding advertisements of interest rates and stresses the importance of accuracy of advertisements. The following section is an excerpt of text of Regulation Q. § 326. 1991. 1999 .1 Authority. 17917.http://www. (ii) The amount of currency or other valuables exposed to robbery. if the vault is visible from outside the banking office. effective May 3. The security officer for each insured nonmember bank shall report at least annually to the bank's board of directors on the implementation. and scope.html.181 (2) A lighting system for illuminating.2265}} [Codified to 12 C.) 12. administration. April 3.R.R. and (vi) The physical characteristics of the structure of the banking office and its surroundings.prohibits the payment of interest on demand deposits by member banks and other depository institutions.fdic.gov/regulations/laws/rules/10000-3. and larceny. 1991] § 326.F. 1991. Reg. during the hours of darkness. (3) An alarm system or other appropriate device for promptly notifying the nearest responsible law enforcement officers of an attempted or perpetrated robbery or burglary.3] [Section 326. Reg. 181 . purpose. The regulations require banks to utilize “truth in advertising”.4 amended at 53 Fed. 1991] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 23. 56 Fed. 217. thus. Reg. 13582. 505). (a) Demand deposit means any deposit that is considered to be a demand deposit under Sec. except as may be otherwise provided by the Board.2 Definitions. (c) Scope. et seq. 182 .S.C. 21. as amended at 57 FR 43336.C. (b) Purpose. 204. 204. 1986.3 Interest on demand deposits. section 11 of the Federal Reserve Act (12 U.2(b) of the Board's Regulation D--Reserve Requirements of Depository Institutions (12 CFR part 204). Sept. Sec.S. and section 8 of the Federal Deposit Insurance Act (12 U. this regulation does not apply to ‘any deposit that is payable only at an office located outside of the United States'' (i.e.Reserve Requirements of Depository Institutions (12 CFR 20. 20. (ii) Its parent foreign bank is controlled by a foreign company which owns or controls foreign banks that in the aggregate have total worldwide consolidated bank assets in excess of $1 billion.182 (a) Authority. Q.S. if: (i) Its parent foreign bank has total worldwide consolidated bank assets in excess of $1 billion. (b) Deposit means any liability of a member bank that is considered to be a deposit under Sec. 1818).2(t) of the Board's Regulation D-. 461. the following definitions apply unless otherwise specified.S. This part prohibits the payment of interest on demand deposits by member banks and other depository institutions within the scope of this part. [Reg. 217.C. The regulation also applies to any Federal branch or agency of a foreign bank and to a State uninsured branch or agency of a foreign bank in the same manner and to the same extent as if the branch or agency were a member bank.4). Mar.2(a) of the Board's Regulation D--Reserve Requirements of Depository Institutions (12 CFR part 204). 204.2(o) of the Board's Regulation D--Reserve Requirements of Depository Institutions (12 CFR part 204).S. For purposes of this part. 3105). 321. the States of the United States and the District of Columbia) as defined in Sec.C. 248). (1) This regulation applies to state chartered banks that are members of the Federal Reserve under section 9 of the Federal Reserve Act (12 U. or (iii) Its parent foreign bank is controlled by a group of foreign companies that own or control foreign banks that in the aggregate have total worldwide consolidated bank assets in excess of $1 billion. 204. 1992] Sec. (2) For deposits held by a member bank or a foreign bank. unless otherwise noted. section 7 of the International Banking Act of 1978 (12 U.C. (d) Interest means any payment to or for the account of any depositor as compensation for the use of funds constituting a deposit.) and to all national banks. 371a.. 217. This part is issued under the authority of section 19 of the Federal Reserve Act (12 U. (c) Foreign bank means any bank that is considered to be a foreign bank under Sec. 51 FR 9637. A member bank's absorption of expenses incident to providing a normal banking function or its forbearance from charging a fee in connection with such a service is not considered a payment of interest. provided that such certificate is renewed within ten calendar days after maturity. Sept. in the case. and (3) The value of the premium or. and handling costs) does not exceed $10 for deposits of less than $5. The member bank should retain sufficient supporting documentation showing that the total cost of a premium. 1987.\1\ \1\ A member bank may continue to pay interest on a time deposit for not more than ten calendar days.html) 13.gov/nara/cfr/waisidx/12cfrv2. 204. packaging. packaging. directly or indirectly. May 15.000 or more. any premium that is not. shipping. including shipping. Redesignated at 57 FR 43336. Regulation U – Interest on Deposits .8(a)(2) of Regulation D). the total cost (including taxes. (b) Notwithstanding paragraph (a) of this section. if the deposit or any portion thereof is withdrawn not more than ten calendar days after a maturity date (one business day for ``IBF time deposits'' as defined in Sec. A member bank is not permitted directly or indirectly to solicit or promote deposits from customers on the basis that the funds will be divided into more than one account by the institution for the purpose of providing more than two premiums per deposit within a 12-month period. by any device whatsoever. warehousing. Premiums. (2) No more than two premiums per account are given within a 12-month period. 21.imposes credit restrictions upon persons other than brokers or dealers (hereinafter lenders) that extend credit for the purpose of buying or carrying margin stock if the credit is secured directly or indirectly by margin stock. 1999 . interest will continue to be paid for such period. [52 FR 47698.3 of Regulation Q prohibits a member bank from paying interest on a demand deposit. whether in the form of merchandise.gpo. (1) Where the member bank has provided in the time deposit contract that. 62 FR 26737. directly or indirectly. (a) Section 19(i) of the Federal Reserve Act and Sec. Dec. given by a member bank to a depositor will be regarded as an advertising or promotional expense rather than a payment of interest if: (1) The premium is given to a depositor only at the time of the opening of a new account or an addition to an existing account. The costs of premiums may not be averaged. of articles of merchandise. Lenders 183 . pay any interest on any demand deposit. or (2) for a period between a maturity date and the date of renewal of the deposit. or cash.access. advertising.183 No member bank of the Federal Reserve System shall. or other expenses. credit.000 or $20 for deposits of $5. promotional. related to or dependent on the balance in a demand deposit account and the duration of the account balance shall not be considered the payment of interest on a demand deposit account and shall not be subject to the limitations in paragraph (a) of this section. 1997] (The information above was taken from the Code of federal Regulations Web site on December 4. Sec.101 Premiums on deposits. 217. warehousing. does not exceed the applicable $10/$20 limitations and that no portion of the total cost of any premium has been attributed to development. 1992. 217. and handling costs.http://www. 16. 184 may not extend more than the maximum loan value of the collateral securing such credit. or guarantee of. The following section is an excerpt of text of Regulation U. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. as defined in Sec. (2) This part does not apply to clearing agencies regulated by the Securities and Exchange Commission or the Commodity Futures Trading Commission that accept deposits of margin stock in connection with: (i) The issuance of. or (ii) The guarantee of contracts for the purchase or sale of a commodity for future delivery or options on such contracts. Regulation U (this part) is issued by the Board of Governors of the Federal Reserve System (the Board) pursuant to the Securities Exchange Act of 1934 (the Act) (15 U. Sec. 221. (2) Maintaining credit. or the clearance of transactions in. 221. 221. purpose. 78a et seq. (a) Authority.2) and other persons who are required to register with the Board under Sec. in an amount that exceeds the maximum loan value of the collateral securing the credit. securities index or foreign currency).1 Authority. A bank may continue to maintain any credit initially extended in compliance with this part. (b) Purpose and scope. and arranging credit--(1) Extending credit. (ii) Change in the maximum loan value prescribed by this part.). and scope. secured directly or indirectly by margin stock.7 (the Supplement). The forms referenced in this part are available from the Federal Reserve Banks. 184 .8 of this part) is assigned by the Board in terms of a percentage of the current market value of the margin stock.S.C.2(f) of this part. The maximum loan value of margin stock (set forth in Sec. Lenders include ``banks'' (as defined in Sec. 221.3 General requirements. as set by the Board in Sec. maintaining. 221. (a) Extending. Lenders may not extend more than the maximum loan value of the collateral securing such credit. (c) Availability of forms. (3) This part does not apply to credit extended to an exempted borrower. any security (including options on any security. regardless of: (i) Reduction in the customer's equity resulting from change in market prices. (1) This part imposes credit restrictions upon persons other than brokers or dealers (hereinafter lenders) that extend credit for the purpose of buying or carrying margin stock if the credit is secured directly or indirectly by margin stock. All other collateral has good faith loan value. No bank shall extend any purpose credit. or (iii) Change in the status of the security (from nonmargin to margin) securing an existing purpose credit. 221. 221. certificate of deposit.3(b). (f) Withdrawals and substitutions. which shall be signed and accepted by a duly authorized officer of the bank acting in good faith.185 (3) Arranging credit. under a revolving-credit or other multiple-draw agreement. For any purpose credit disbursed under the agreement. the maximum loan value of the collateral on the day of the withdrawal or substitution shall be used.000. (c) Purpose statement for revolving-credit or multiple-draw agreements. recapitalization or exchange offer that is made to holders of an issue of margin stock. or (ii) Increase the amount by which the credit exceeds the maximum loan value of the collateral. secured directly or indirectly by any margin stock. whenever a bank extends credit secured directly or indirectly by any margin stock. To enable a customer to participate in a reorganization. (b) Purpose statement. (g) Exchange offers.000. A purpose credit secured in part by margin stock. (d) Single credit rule. No bank may arrange for the extension or maintenance of any purpose credit. (3) If a bank extended unsecured purpose credit to a customer prior to the extension of purpose credit secured by margin stock. except upon the same terms and conditions under which the bank itself may extend or maintain purpose credit under this part. Form FR U-1 can either be executed each time a disbursement is made under the agreement. (2) If a purpose statement executed at the time the credit arrangement is initially made indicates that the purpose is to purchase or carry margin stock. the bank shall obtain and attach to the executed Form FR U-1 a current list of collateral which adequately supports all credit extended under the agreement. or at the time the credit arrangement is originally established. one secured by margin stock and one by all other collateral. (e) Mixed collateral loans. (2) For purposes of this section. (1) All purpose credit extended to a customer shall be treated as a single credit. (1) If a bank extends credit. if it maintains records identifying each portion of the credit and its collateral. in an amount exceeding $100. A bank may use a single credit agreement. (4) If a bank extends purpose credit secured by any margin stock and non-purpose credit to the same customer. the credits shall be combined and treated as a single credit solely for the purposes of the withdrawal and substitution provision of paragraph (f) of this section. (1) A bank may permit any withdrawal or substitution of cash or collateral by the customer if the withdrawal or substitution would not: (i) Cause the credit to exceed the maximum loan value of the collateral. the credit will be deemed in compliance with this part if the maximum loan value of the collateral at least equals the aggregate amount of funds actually disbursed. the bank shall treat the credits as two separate loans and may not rely upon the required collateral securing the purpose credit for the nonpurpose credit. (2) A bank that has extended purpose credit secured by margin stock may not subsequently extend unsecured purpose credit to the same customer unless the combined credit does not exceed the maximum loan value of the collateral securing the prior credit. and all the collateral securing such credit shall be considered in determining whether or not the credit complies with this part. 7100-0115). Except for credit extended under paragraph (c) of this section. and in part by other collateral shall be treated as two separate loans. in an amount exceeding $100. a bank 185 . the bank shall require its customer to execute Form FR U-1 (OMB No. Dec. Sept. (k) Mistakes in good faith. (3) When a transfer is made between banks or between a bank and a lender subject to part 207 of this chapter. Failure to treat an NMS security as a margin stock in connection with an extension of credit shall not be deemed a violation of this part if the designation is made between quarterly publications of the Board's List of OTC Margin Stocks and the bank does not have actual notice of the designation. 56 FR 66120. (a) Maximum loan value of margin stock. maximum loan value of margin stock and other collateral.186 may permit substitution of the securities received. 23. 48 FR 35076. A nonmargin. 221. nonexempted security acquired in exchange for a margin stock shall be treated as if it is margin stock for a period of 60 days following the exchange. A renewal or extension of maturity of a credit need not be considered a new extension of credit if the amount of the credit is increased only by the addition of interest. 10. 52 FR 35683. (ii) The transfer is not made to evade this part or part 207 of this chapter. Nothing in this part shall require a bank to waive or forego any lien or prevent a bank from taking any action it deems necessary in good faith for its protection. Sept. Aug. 186 . calls. (1) A transfer of a credit between customers or banks or between a bank and a lender subject to part 207 of this chapter shall not be considered a new extension of credit if: (i) The original credit was extended by a bank in compliance with this part or by a lender subject to part 207 of this chapter in a manner that would have complied with this part. The bank shall keep such statement with its records of the transferee account. 56 FR 46111. the transferee may accept in good faith a statement from the transferor describing the purpose of the loan and the collateral securing it. Sept. The maximum loan value of any margin stock expect options is fifty per cent of its current market value. 1991. (l) Lack of notice of NMS security designation. (b) Maximum loan value of nonmargin stock and all other collateral. If no form was originally filed with the transferor. 1984. and (iv) The collateral for the credit is not changed. as amended at 49 FR 35758. (i) Transfers of credit. (h) Renewals and extensions of maturity. 1987. A mistake in good faith in connection with the extension of maintenance of credit shall not be a violation of this part. (j) Action for bank's protection. the transferee shall obtain a copy of the Form FR U-1 or Form FR G-3 originally filed with the transferor and retain the copy with its records of the transferee account.8 Supplement. 12. [Reg. or combinations thereof is their good faith loan value. (iii) The amount of credit is not increased. service charges. 3. 1991] Sec. 20. The maximum loan value of nonmargin stock and all other collateral except puts. or taxes with respect to the credit. 1983. U. (2) Any transfer between customers at the same bank shall be accompanied by a statement by the transferor customer describing the circumstances giving rise to the transfer and shall be accepted and signed by an officer of the bank acting in good faith. S.C. (2) Define and regulate the nonbanking activities in which bank holding companies and foreign banking organizations with United States operations may engage.http://www.S. L. (The information above was taken from the Code of federal Regulations Web site on December 4. The Board's Regulation K governs certain nonbanking activities conducted by foreign 187 . part 225. (c) Scope--(1) Subpart A contains general provisions and definitions of terms used in this regulation. and the International Lending Supervision Act of 1983 (Pub. and scope. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. title 12. Except for purposes of Sec. and • Set forth the procedures for securing approval for these transactions and activities The Bank Holding Company act of 1956 was designed to control interstate banking activities by requiring that the State being expanded into specifically allowed the formation of an interstate bank. (a) Authority.S. section 8(b) of the Federal Deposit Insurance Act (12 U. • Define and regulate the nonbanking activities in which bank holding companies and foreign banking organizations with United States operations may engage. 1972). and (3) Set forth the procedures for securing approval for these transactions and activities.S.C. chapter II. calls. 3106 and 3108).C. et seq. The BHC Act is codified at 12 U.C.C. 221.purpose is to: • Regulate the acquisition of control of banks by companies and individuals. 98-181.C. section 914 of the Financial Institutions Reform. The principal purposes of this part are to: (1) Regulate the acquisition of control of banks by companies and individuals. as amended (12 U. (b) Purpose.1 Authority.S.S. 1844(b)) (BHC Act). puts. 225.5(c)(10) of this part. 1817(j)(13)) (Bank Control Act). and combinations thereof have no loan value. section 7(j)(13) of the Federal Deposit Insurance Act. This part <SUP>1</SUP> (Regulation Y) is issued by the Board of Governors of the Federal Reserve System (Board) under section 5(b) of the Bank Holding Company Act of 1956.access. sections 8 and 13(a) of the International Banking Act of 1978 (12 U. title IX).187 (c) Maximum loan value of options. 1841.gpo.S. purpose. as amended by the Change in Bank Control Act of 1978 (12 U.html) 14. Recovery and Enforcement Act of 1989 (12 U. \1\ Code of Federal Regulations.gov/nara/cfr/waisidx_98/12cfrv3_98. section 106 of the Bank Holding Company Act Amendments of 1970 (12 U. 1818(b)). Regulation Y – Bank Holding Company Act . 1999 . (2) Subpart B governs acquisitions of bank or bank holding company securities and assets by bank holding companies or by any company that will become a bank holding company as a result of the acquisition. 1831i). (3) Subpart C defines and regulates the nonbanking activities in which bank holding companies and foreign banking organizations may engage directly or through a subsidiary. The following section is an excerpt of text of Regulation Y.C. 1997. Feb. purpose.S.gpo. (13) Appendix E contains the Board's Capital Adequacy Guidelines for measuring market risk of bank holding companies. The regulation gives consumers the right to cancel certain credit transactions that involve a lien on a consumer's principal dwelling. enforcement and liability. (7) Subpart G prescribes minimum standards that apply to the performance of real estate appraisals and identifies transactions that require state certified appraisers. (8) Subpart H identifies the circumstances when written notice must be provided to the Board prior to the appointment of a director or senior officer of a bank holding company and establishes procedures for obtaining the required Board approval.] (The information above was taken from the Code of federal Regulations Web site on December 4. Regulation Z – Truth in Lending . and provides a means for fair and timely resolution of credit billing disputes. 62 FR 9319. 188 .html) 15. known as Regulation Z. which is contained in title I of the Consumer Credit Protection Act. Y.http://www. and provides rules governing the effectiveness of divestitures by bank holding companies. (10) Appendix B contains the Board's Capital Adequacy Guidelines for measuring leverage for bank holding companies and state member banks. as amended (15 U. This regulation. (9) Appendix A to the regulation contains the Board's Risk-Based Capital Adequacy Guidelines for bank holding companies. [Reg. coverage. 226.gov/nara/cfr/waisidx_98/12cfrv3_98. unless otherwise noted. (4) Subpart D specifies situations in which a company is presumed to control voting securities or to have the power to exercise a controlling influence over the management or policies of a bank or other company.1 Authority. (6) Subpart F specifies the limitations that govern companies that control so-called nonbank banks and the activities of nonbank banks. organization. regulates certain credit card practices. 28. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. 1999 . (a) Authority.188 banking organizations and certain foreign activities conducted by bank holding companies (12 CFR part 211.access. The following section is an excerpt of text of Regulation Z.purpose is to promote the informed use of consumer credit by requiring disclosures about its terms and cost. is issued by the Board of Governors of the Federal Reserve System to implement the Federal Truth in Lending Act. (5) Subpart E governs changes in bank control resulting from the acquisition by individuals or companies (other than bank holding companies) of voting securities of a bank holding company or state member bank of the Federal Reserve System. (11) Appendix C contains the Board's policy statement governing small bank holding companies.C. International Banking Operations). (12) Appendix D contains the Board's Capital Adequacy Guidelines for measuring tier 1 leverage for bank holding companies. sets forth the procedures for making a control determination. It sets forth: (i) The authority. respectively. 100-86. and (iv) the method of determining the finance charge. 130. (5) Subpart E relates to mortgage transactions covered by Sec. It requires that initial disclosures and periodic statements be provided. section 1204 of the Competitive Equality Banking Act of 1987 (Pub. family. coverage. rescission requirements. purpose. and advertising. a list of enforcement agencies. record retention. (ii) the definitions of basic terms. It also imposes limitations on home equity plans that are subject to the requirements of Sec.S. (1) In general. 101 Stat. and organization of the regulation. The regulation is divided into subparts and appendices as follows: (1) Subpart A contains general information. Sections 112. Spanish language disclosure in Puerto Rico. The regulation does not govern charges for consumer credit.5a and 226. and 134 contain provisions relating to 189 . or household purposes. 226.32 and reverse mortgage transactions. however. fees. effect on state laws. It contains rules on disclosures. and the rules for computing annual percentage rates in closed-end credit transactions and total annual loan cost rates for reverse mortgage transactions. state exemptions and issuance of staff interpretations. 113. (c) Coverage. L. (d) Organization. 552). 226. The regulation requires a maximum interest rate to be stated in variable-rate contracts secured by the consumer's dwelling. (2) If a credit card is involved. or if the credit card is to be used for business purposes. 226. 131.5b apply to persons who are not creditors but who provide applications for home equity plans to consumers.C. annual percentage rate calculations. or is not payable by a written agreement in more than 4 installments.189 1601 et seq. as well as additional disclosures for credit and charge card applications and solicitations and for home equity plans subject to the requirements of Secs. (b) The purpose of this regulation is to promote the informed use of consumer credit by requiring disclosures about its terms and cost. this regulation applies to each individual or business that offers or extends credit when four conditions are met: (i) The credit is offered or extended to consumers. and provides a means for fair and timely resolution of credit billing disputes. It contains rules on disclosures. and (iv) the credit is primarily for personal. certain provisions apply even if the credit is not subject to a finance charge. 3501 et seq. (3) In addition. 226. (2) Subpart B contains the rules for open-end credit. and have been assigned OMB number 7100-0199.).32. This regulation also implements title XII. The regulation gives consumers the right to cancel certain credit transactions that involve a lien on a consumer's principal dwelling. (iii) the transactions that are exempt from coverage. treatment of credit balances. state exemptions. 226. and rate limitations.5b. (e) Enforcement and liability. Section 108 of the act contains the administrative enforcement provisions.5b and mortgages that are subject to the requirements of Sec. regulates certain credit card practices. and total annual loan cost rates. (ii) the offering or extension of credit is done regularly. Information-collection requirements contained in this regulation have been approved by the Office of Management and Budget under the provisions of 44 U. (iii) the credit is subject to a finance charge or is payable by a written agreement in more than 4 installments. (3) Subpart C relates to closed-end credit. certain requirements of Sec. special rules for certain kinds of credit plans. (6) Several appendices contain information such as the procedures for determinations about state laws. (4) Subpart D contains rules on oral disclosures. 9. 7. and 190 . incorporates by reference administrative enforcement and civil liability provisions of sections 108 and 130 of the act. The Board of Governors of the Federal Reserve System (the Board) issues this part to implement the Community Reinvestment Act (12 U. 1842). TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. Regulation BB – Community Reinvestment Act .190 liability for failure to comply with the requirements of the act and the regulation. 1987. and to take this record into account in the agency's evaluation of an application for a deposit facility by the institution. (2) To conduct examinations of bank holding companies and their subsidiaries (12 U. 1828(c)). 228. and to take this record into account in the agency's evaluation of an application for a deposit facility by the institution. June 9. acquisitions of banks by.C. the Congress required each appropriate Federal financial supervisory agency to assess an institution's record of helping to meet the credit needs of the local communities in which the institution is chartered. 1999 . Apr.and moderateincome neighborhoods.C. Z. 321). purposes. 325).S. Section 1204(c) of title XII of the Competitive Equality Banking Act of 1987. This part is intended to carry out the purposes of the CRA by: (1) Establishing the framework and criteria by which the Board assesses a bank's record of helping to meet the credit needs of its entire community. 552. (iii) Formations of. The regulations comprising this part are issued under the authority of the CRA and under the provisions of the United States Code authorizing the Board: (1) To conduct examinations of State-chartered banks that are members of the Federal Reserve System (12 U. L. 6.C.C. (b) Purposes.gpo. 1844). (a) Authority. 1981. 54 FR 13865.access. 46 FR 20892.11 Authority. including low. 24.C. 1989. (ii) Mergers in which the resulting bank would be a State member bank (12 U. The following section is an excerpt of text of Regulation BB. 1995] (The information above was taken from the Code of federal Regulations Web site on December 4.S. consistent with the safe and sound operation of the institution.http://www. 54 FR 24686. and mergers of. consistent with the safe and sound operation of the institution. bank holding companies (12 U. 100-86.C. Mar.S. and (3) To consider applications for: (i) Domestic branches by State member banks (12 U.S. consistent with the safe and sound operation of the bank.S.purpose is to assess an institution's record of helping to meet the credit needs of the local communities in which the institution is chartered. 2901 et seq.) (CRA). and (iv) The acquisition of savings associations by bank holding companies (12 U. as amended at 52 FR 43181. In enacting the CRA.S.gov/nara/cfr/waisidx_98/12cfrv3_98.html) 16. 1989. [Reg.S. Apr.C. and scope. Nov. 1843). 60 FR 15471. Pub. 101 Stat. 3103(a)(8)).gpo. L. and organization. This part is divided into subparts and appendices as follows-(1) Subpart A contains general information. 101 Stat. Regulation CC – Availability of Funds and Collections of Checks . as defined in 12 U. organization.). L. 28. as amended by section 1001 of the Cranston-Gonzalez National Affordable Housing Act of 1990 (Pub. This part (Regulation CC. 635). 2236. 3101 et seq.purpose is to assess an institution's record of helping to meet the credit needs of the local communities in which the institution is chartered. [Reg. 101-625. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec. L. and 227 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (Pub. 2303. The terms ``State branch'' and ``foreign bank'' have the same meanings as in section 1(b) of the International Banking Act of 1978 (12 U. the term ``uninsured State branch'' means a State branch the deposits of which are not insured by the Federal Deposit Insurance Corporation.] (The information above was taken from the Code of federal Regulations Web site on December 5. and to take this record into account in the agency's evaluation of an application for a deposit facility by the institution. It sets forth-(i) The authority.S. This part also applies to an uninsured State branch (other than a limited branch) of a foreign bank that results from an acquisition described in section 5(a)(8) of the International Banking Act of 1978 (12 U. and banks that engage only in one or more of the following activities: providing cash management controlled disbursement services or serving as correspondent banks. 100-86. This part does not apply to special purpose banks that do not perform commercial or retail banking services by granting credit to the public in the ordinary course of business. 1997. 4424) and sections 212(h). 24 (Seventh). 62 FR 9319. 12 CFR part 229) is issued by the Board of Governors of the Federal Reserve System (Board) to implement the Expedited Funds Availability Act (Act) (title VI of Pub. 105 Stat. 1999 . Feb. 191 .C. unless otherwise noted. (a) Authority and purpose. 225.html) 17.). trust companies. 4079. (2) Foreign bank acquisitions.http://www.gov/nara/cfr/waisidx_98/12cfrv3_98. The following section is an excerpt of text of Regulation CC. (c) Scope--(1) General. Y.access.C. 102-242.C. consistent with the safe and sound operation of the institution.191 (2) Providing that the Board takes that record into account in considering certain applications. (3) Certain special purpose banks. 104 Stat. 2307).1 Authority and purpose. 229. the term ``limited branch'' means a State branch that accepts only deposits that are permissible for a corporation organized under section 25A of the Federal Reserve Act (12 U.C.S. 611 et seq. other than as incident to their specialized operations. (b) Organization. or clearing agents. 552.S. These banks include banker's banks. purpose. This part applies to all banks except as provided in paragraph (c)(3) of this section.S. Oct. 1988. 3. coverage. Aug. notification of nonpayment by the paying bank. State law requirements that are inconsistent with the requirements of the act and this part are preempted to the extent of the inconsistency. 1992. indorsement and presentment of checks.. 7100-0255. Oct. Subpart B of this part also contains rules regarding exceptions to the schedules.gov/nara/cfr/waisidx_98/12cfrv3_98. 230. the liability of banks for failure to comply with subpart C of this part. and other matters. 1992. TITLE 12--BANKS AND BANKING CHAPTER II--FEDERAL RESERVE SYSTEM Sec.access. (d) Effect on state laws. 105 Stat. 3501 et seq. and (iii) Authority for administrative enforcement of this part's provisions.192 (ii) Definition of terms. 192 . [53 FR 19433. same-day settlement for certain checks.8 of this part apply to any person who advertises an account offered by a depository institution. including deposit brokers. 14. is issued by the Board of Governors of the Federal Reserve System to implement the Truth in Savings Act of 1991 (the act).C. Regulation DD – Truth in Savings . and other matters. known as Regulation DD. (b) Purpose. and effect on state laws. The purpose of this part is to enable consumers to make informed decisions about accounts at depository institutions.html) 18. 1999 .1 Authority.S. Pub. L. including availability schedules. These rules cover the direct return of checks.http://www. (2) Subpart B of this part contains rules regarding the duty of banks to make funds deposited into accounts available for withdrawal. 4301 et seq. purpose. the manner in which the paying bank and returning banks must return checks to the depositary bank. payment of interest.gpo. 1995] (The information above was taken from the Code of federal Regulations Web site on December 5. This part applies to depository institutions except for credit unions. (a) Authority. Information collection requirements contained in this part have been approved by the Office of Management and Budget under the provisions of 44 U. This part requires depository institutions to provide disclosures so that consumers can make meaningful comparisons among depository institutions. This part requires depository institutions to provide disclosures so that consumers can make meaningful comparisons among depository institutions.S. and have been assigned OMB No. Additional information on inconsistent state laws and the procedures for requesting a preemption determination from the Board are set forth in appendix C of this part. 230. 14. Reg. as amended at 57 FR 36598. 2236). CC. 102-242. May 27. The following section is an excerpt of text of Regulation DD.purpose is to enable consumers to make informed decisions about accounts at depository institutions. (3) Subpart C of this part contains rules to expedite the collection and return of checks by banks. In addition.C. This part. 60 FR 51670. contained in the Federal Deposit Insurance Corporation Improvement Act of 1991 (12 U. the advertising rules in Sec. liability of banks for failure to comply with Subpart B of this part. disclosure of funds availability policies. 57 FR 46972. (c) Coverage. arrange. Construction project loans are not subject to subparts A and B of this part.gov/nara/cfr/waisidx_98/12cfrv3_98. (c) State law limitations means any State statute. or judicial decision interpreting State law. DEPARTMENT OF THE TREASURY Sec.C. 1999 . [61 FR 11300.3 General rule. subject to terms. American Samoa. or interests in.193 (The information above was taken from the Code of federal Regulations Web site on December 5. or (2) A residential or farm building. (b) Scope. 371 and subparts A and B of this part. real estate. loans secured by liens on interests in real estate include loans made upon the security of condominiums.] 193 . Puerto Rico. unless otherwise noted. TITLE 12--BANKS AND BANKING CHAPTER I--COMPTROLLER OF THE CURRENCY. and construction project loans. purchase. contract. 20. (a) Due-on-sale clause means any clause that gives the lender or any assignee or transferee of the lender the power to declare the entire debt payable if all or part of the legal or equitable title or an equivalent contractual interest in the property securing the loan is transferred to another person. regulation.2 Definitions. 34.access. cooperatives. The following section is an excerpt of text of Regulation 34.html) 19.34. land sales contracts.gpo. (b) State means any State of the United States of America. or order of any State agency.purpose is to set forth standards for real estate-related lending and associated activities by national banks. however.http://www. 34. whether by deed. forest tracts. or interests therein. the District of Columbia. or sell loans or extensions of credit. Sec. and limitations prescribed by the Comptroller of the Currency by regulation or order. leaseholds. A national bank may make. The purpose of this part is to set forth standards for real estate-related lending and associated activities by national banks. This part applies to national banks and their operating subsidiaries as provided in 12 CFR 5. (a) Purpose. if they have a maturity not exceeding 60 months and are made to finance the construction of either: (1) A building where there is a valid and binding agreement entered into by a financially responsible lender or other party to advance the full amount of the bank's loan upon completion of the building. For the purposes of 12 U.1 Purpose and scope. 34. the Virgin Islands. and Guam. Mar. or otherwise. the Northern Mariana Islands. that are secured by liens on. conditions. 1996.S. Sec. Regulation 34 – Real Estate Lending and Appraisals . or imprisoned not more than 30 years. or corruptly accepts or agrees to accept. 194 . 99--370. offered. accepted. 100 Stat.194 (The information above was taken from the Code of federal Regulations Web site on December 5.C.html#8284 21. solicited. solicited. Compliance with the Act is extremely important as civil and criminal penalties can be imposed including the termination of banking licenses. employee. fees.access. No. with intent to influence or reward an officer.S. The following section is an excerpt of text of the Bank Bribery Act.purpose is to govern the activities of financial institution employees regarding the receipt of anything in value in return for favorable loan procurements. (d) Federal agencies with responsibility for regulating a financial institution shall jointly establish such guidelines as are appropriate to assist an officer. offered.was passed in 1970 to require banks to document and file certain transaction reports for possible use in criminal. or other compensation paid.http://www. L. 1986 (Pub. may be cited as the "Bank Bribery Amendments Act of 1985. which amends section 215.http://www. § 215.gov/cgi-bin/cfrassemble. demanded. offers. Receipt of commissions or gifts for procuring loans. Bank Bribery Act . demanded. or promises anything of value to any person.cgi?title=199812 20. 215] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 21. The regulations emphasize the development and implementation of “know your customer” policies and procedures by banks. but if the value of the thing given. or agreed to be accepted.{*} (a) Whoever-(1) corruptly gives. or attorney of a financial institution to comply with this section. whichever is greater. intending to be influenced or rewarded in connection with any business or transaction of such institution. or both. or expenses paid or reimbursed. or attorney of a financial institution in connection with any business or transaction of such institution. shall be fined under this title or three times the value of the thing given. (b) [Revoked] (c) This section shall not apply to bona fide salary. corruptly solicits or demands for the benefit of any person.gpo. in the usual course of business.gov/regulations/laws/rules/8000-7. accepted. employee. or agreed to be accepted does not exceed $1. The purpose was to provide an audit trail of banking transactions to reduce the potential for money laundering activities by those involved in illegal activities. agent. 1999 . {* The Act of August 4. director. 779). or (2) as an officer. wages. director.000. employee. or attorney of a financial institution. director. promised. agent. Bank Secrecy Act . anything of value from any person. promised. agent. or both. 1999 . tax."} [Codified to 18 U. Such agencies shall make such guidelines available to the public.fdic. shall be fined under this title or imprisoned not more than one year. or regulatory proceedings. 21. (2) Provide for independent testing for compliance to be conducted by bank personnel or by an outside party. approved by the board of directors and noted in the minutes. have been of particular value in this respect. and regulatory investigations and proceedings. The compliance program shall be reduced to writing. at a minimum: (1) Provide for a system of internal controls to assure ongoing compliance.195 Each bank is required to develop and provide for the continued administration of a program reasonably designed to assure and monitor compliance with the recordkeeping and reporting requirements. Subpart C--Procedures for Monitoring Bank Secrecy Act Compliance Sec. tax. each bank shall develop and provide for the continued administration of a program reasonably designed to assure and monitor compliance with the recordkeeping and reporting requirements set forth in subchapter II of chapter 53 of title 31. United States Code. The compliance program shall. (Approved by the Office of Management and Budget under control number 1557-0180) [52 FR 2859.21 Bank Secrecy Act compliance. (c) Contents of compliance program. tax. 21 (a)(1) The Congress finds that adequate records maintained by insured depository institutions have a high degree of usefulness in criminal. The Congress further finds that microfilm or other reproductions and other records made by banks of checks. DEPARTMENT OF THE TREASURY Sec. or regulatory investigations or proceedings. (3) Designate an individual or individuals responsible for coordinating and monitoring day-to-day compliance. 1987] 195 . The following section is an excerpt of text of the Bank Secrecy Act. as well as records kept by banks of the identity of persons maintaining or authorized to act with respect to accounts therein. (b) Compliance procedures. United States Code. 27. Jan. 1987. and (4) Provide training for appropriate personnel. (a) Purpose. TITLE 12--BANKS AND BANKING CHAPTER I--COMPTROLLER OF THE CURRENCY. This subpart is issued to assure that all national banks establish and maintain procedures reasonably designed to assure and monitor their compliance with the requirements of subchapter II of chapter 53 of title 31. (2) It is the purpose of this section to require the maintenance of appropriate types of records by insured depository institutions in the United States where such records have a high degree of usefulness in criminal. and the implementing regulations promulgated thereunder by the Department of Treasury at 31 CFR part 103. On or before April 27. and the implementing regulations promulgated thereunder by the Department of Treasury at 31 CFR part 103. (5) Totaling more than $10.000. is deemed to do so ``at one time'' if: (1) That person either alone. but are not limited to: (A) Purchases of chips.23. is about to or attempts to transport. or causes the transportation. or causes the transportation.) The following information details some requirement outlined in the Code of Federal Regulations. The reporting rules relating to aggregation are stated in paragraph (c) of this section. in conjunction with or on behalf of others. (i) Transactions in currency involving cash in include. tokens.000. 103. (C) Safekeeping deposits. For purposes of Sec. mails. shipment or receipt in any manner of. (2) Transports. ships or receives. (4) Into the United States or out of the United States. shipment or receipt of monetary instruments.html. mailing. of more than $10. on one or more days. a person who transports. or to such financial institution which involves a transaction in currency of more than $10. (D) Payments on any form of credit.000. 103.196 (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 23. Each financial institution other than a casino shall file a report of each deposit. 103.22 Reports of transactions in currency. Each casino shall file a report of each transaction in currency. In the case of the Postal Service. (B) Front money deposits. ships or receives in any manner. 1999 . involving either cash in or cash out. (b) Filing obligations—(1) Financial institutions other than casinos. (E) Bets of currency. (F) Currency received by a casino for transmittal of funds through wire transfer for a customer. the obligation contained in the preceding sentence shall not apply to payments or transfers made solely in connection with the purchase of postage or philatelic products. and plaques. (2) Casinos. mailing. mail or ship. (6)(i) On one calendar day or (ii) if for the purpose of evading the reporting requirements of Sec. mails. withdrawal. except as otherwise provided in this section. including markers and counter checks.fdic. This section sets forth the rules for the reporting by financial institutions of transactions in currency.gov/regulations/laws/rules/10000-3. (a) General. through. is about to transport. The reporting obligations themselves are stated in paragraph (b) of this section. mail or ship in any manner. (3) Monetary instruments. Rules permitting banks to exempt certain transactions from the reporting obligations appear in paragraph (d) of this section.23 of this part. 196 .http://www. by. (b) At one time. exchange of currency or other payment or transfer. including slot jackpots. In the case of financial institutions other than casinos. For purposes of this paragraph (c)(3). (c) Aggregation—(1) Multiple branches. (E) Payments on bets. and which contain information that such multiple currency transactions have occurred. multiple currency transactions shall be treated as a single transaction if the casino has knowledge that they are by or on behalf of any person and result in either cash in or cash out totaling more than $10.000 during any one business day (or in the case of the Postal Service. tokens. for purposes of this section. (2) Multiple transactions—general. or. (F) Payments by a casino to a customer based on receipt of funds through wire transfer for credit to a customer. In the case of a casino. officer. including foreign currency. and plaques. partner. (D) Advances on any form of credit. for purposes of this section’s reporting requirements. (C) Safekeeping withdrawals. A financial institution includes all of its domestic branch offices. director. and any recordkeeping facility. or employee of the casino. including markers and counter checks. No bank is required to file a report otherwise required by paragraph (b) of this section with respect to any transaction in currency between an exempt person and such bank. (3) Multiple transactions—casinos. acting within the scope of his or her employment. and (I) Reimbursements for customers’ travel and entertainment expenses by the casino. In addition. that contains records relating to the transactions of the institution’s domestic offices. (B) Front money withdrawals. and (H) Exchanges of currency for currency. Deposits made at night or over a weekend or holiday shall be treated as if received on the next business day following the deposit. a non-bank financial institution is not required to file a report otherwise required by paragraph (b) of this section with respect to a 197 .197 (G) Purchases of a casino’s check. and similar documents and information. if: any sole proprietor. any one day). logs. but are not limited to: (A) Redemptions of chips. to the extent provided in paragraph (d)(6)(vi) of this section. has knowledge that such multiple currency transactions have occurred. which the casino maintains pursuant to any law or regulation or within the ordinary course of its business. multiple currency transactions shall be treated as a single transaction if the financial institution has knowledge that they are by or on behalf of any person and result in either cash in or cash out totaling more than $10. including knowledge from examining the books. between such exempt person and other banks affiliated with such bank. records. (ii) Transactions in currency involving cash out include. (d) Transactions of exempt persons— (1) General. tape or other machine-readable media. information retained on magnetic disk.000 during any gaming day. or in any manual system. wherever located. (G) Cashing of checks or other negotiable instruments. a casino shall be deemed to have the knowledge described in the preceding sentence. C. No. L. No. and other information in a manner which is fair and equitable to the consumer.purpose is to ensure fair and accurate credit reporting to ensure public confidence and to provide for fair and private evaluation of credit worthiness. effective April 25. The following section is an excerpt of text of the Fair Credit Reporting Act. 1681 note] [Source: Section 601 of title VI of the Act of May 29. 84 Stat.gpo. 1971] § 603. 1128).gov/nara/cfr/waisidx_98/12cfrv6_98. and general reputation of consumers. Fair Credit Reporting Act . 91-508. No. 1681] [Source: Section 602 of title VI of the Act of May 29. and a respect for the consumer's right to privacy. impartiality. (b) It is the purpose of this title to require that consumer reporting agencies adopt reasonable procedures for meeting the needs of commerce for consumer credit. 1968 (Pub. (4) There is a need to insure that consumer reporting agencies exercise their grave responsibilities with fairness. and proper utilization of such information in accordance with the requirements of this title. as added by section 601 of title VI of the Act of October 26.html#700 22. 1970 (Pub. § 601. (3) Consumer reporting agencies have assumed a vital role in assembling and evaluating consumer credit and other information on consumers.S. relevancy. 1128). 1968 (Pub.http://www. L. accuracy. No. Definitions and rules of construction 198 . credit standing. 90-321). L. 84 Stat. 91-508. L. character. as added by section 601 of title VI of the Act of October 26. credit capacity. effective April 25. with regard to the confidentiality.C. [Codified to 15 U.access. 1970 (Pub. and unfair credit reporting methods undermine the public confidence which is essential to the continued functioning of the banking system.) (The information above was taken from the Code of Federal Regulations Web site on December 5. [Codified to 15 U. (A limitation on the exemption described in this paragraph (d)(1) is set forth in paragraph (d)(7) of this section. Inaccurate credit reports directly impair the efficiency of the banking system.198 transaction in currency between the institution and a commercial bank. (2) An elaborate mechanism has been developed for investigating and evaluating the credit worthiness. insurance. 1971] § 602. Findings and purpose (a) The Congress makes the following findings: (1) The banking system is dependent upon fair and accurate credit reporting. Short title This title may be cited as the Fair Credit Reporting Act. 90-321). personnel. 1999 .S. or mode of living which is used or expected to be used or collected in whole or in part for the purpose of serving as a factor in establishing the consumer's eligibility for-(A) credit or insurance to be used primarily for personal. or mode of living is obtained through personal interviews with neighbors. friends. and such person makes the disclosures to the consumer required under section 615. or on a cooperative nonprofit basis. association. or (C) any other purpose authorized under section 604. if the third party advises the consumer of the name and address of the person to whom the request was made. credit standing. family. or associates of the consumer reported on or with others with whom he is acquainted or who may have knowledge concerning any such items of information. character. corporation. (B) any authorization or approval of a specific extension of credit directly or indirectly by the issuer of a credit card or similar device. (b) The term "person" means any individual. (ii) communication of that information among persons related by common ownership or affiliated by corporate control. or (iii) communication of other information among persons related by common ownership or affiliated by corporate control.-. general reputation. (B) employment purposes. personal characteristics. trust. or other entity. oral. general reputation. estate. (2) EXCLUSIONS. or other communication of any information by a consumer reporting agency bearing on a consumer's credit worthiness. credit capacity.199 (a) Definitions and rules of construction set forth in this section are applicable for the purposes of this title. (c) The term "consumer" means an individual. if it is clearly and conspicuously disclosed to the consumer that the information may be communicated among such persons and the consumer is given the opportunity. dues. regularly engages in whole or in part in the practice of assembling or evaluating consumer credit information or other information on consumers 199 . (f) The term "consumer reporting agency" means any person which. partnership. such information shall not include specific factual information on a consumer's credit record obtained directly from a creditor of the consumer or from a consumer reporting agency when such information was obtained directly from a creditor of the consumer or from the consumer. government or governmental subdivision or agency.{{4-30-99 p. to direct that such information not be communicated among such persons. (d) CONSUMER REPORT. for monetary fees. cooperative. or household purposes. before the time that the information is initially communicated. personal characteristics.6602}} (1) IN GENERAL. (C) any report in which a person who has been requested by a third party to make a specific extension of credit directly or indirectly to a consumer conveys his or her decision with respect to such request.--The term "consumer report" does not include-(A) any-(i) report containing information solely as to transactions or experiences between the consumer and the person making the report. However.--The term "consumer report" means any written. or (e) The term "investigative consumer report" means a consumer report or portion thereof in which information on a consumer's character. when used in connection with information on any consumer. DECISIONS. any license or benefit described in section 604(a)(3)(D). decisions. and (B) for the purpose of determining whether to extend credit or insurance pursuant to the offer.--For purposes of any determination of whether an action is an adverse action under paragraph (1)(A). and (B) means-(i) a denial or cancellation of. reassignment or retention as an employee. to meet the specific criteria used to select the consumer for the offer. COMMENTARY AND ORDERS. or other medical or medically related facilities.6603}} (A) has the same meaning as in section 701(d)(6) of the Equal Credit Opportunity Act. (g) The term "file". (k) ADVERSE ACTION.--The term "adverse action"-{{4-30-99 p. and (iv) an action taken or determination that is-(I) made in connection with an application that was made by. except that the offer may be further conditioned on one or more of the following: (1) The consumer being determined. in connection with the underwriting of insurance. based on information in a consumer report on the consumer. 200 . (ii) a denial of employment or any other decision for employment purposes that adversely affects any current or prospective employee. with the consent of the individual to whom it relates. that are established-(A) before selection of the consumer for the offer. (l) FIRM OFFER OF CREDIT OR INSURANCE. based on information in the consumer's application for the credit or insurance. (2) APPLICABLE FINDINGS. means all of the information on that consumer recorded and retained by a consumer reporting agency regardless of how the information is stored. or any other adverse or unfavorable change in the terms of. from licensed physicians or medical practitioners. to meet specific criteria bearing on credit worthiness or insurability. hospitals. and which uses any means or facility of interstate commerce for the purpose of preparing or furnishing consumer reports.-(1) ACTIONS INCLUDED. an increase in any charge for.--The term "firm offer of credit or insurance" means any offer of credit or insurance to a consumer that will be honored if the consumer is determined. any consumer. or a transaction that was initiated by.200 for the purpose of furnishing consumer reports to third parties. all appropriate final findings. (iii) a denial or cancellation of. clinics. any insurance. existing or applied for. or a reduction or other adverse or unfavorable change in the terms of coverage or amount of. (h) The term "employment purposes" when used in connection with a consumer report means a report used for the purpose of evaluating a consumer for employment. or in connection with a review of an account under section 604(a)(3)(F)(ii). promotion. commentary. and orders issued under section 701(d)(6) of the Equal Credit Opportunity Act by the Board of Governors of the Federal Reserve System or any court shall apply. as applicable. an increase in any charge for. and (II) adverse to the interests of the consumer. (i) The term "medical information" means information or records obtained. (m) CREDIT OR INSURANCE TRANSACTION THAT IS NOT INITIATED BY THE CONSUMER. (2) that is made to a prospective employer for the purpose of-(A) procuring an employee for the employer.--A communication described in this subsection if it is a communication-. the District of Columbia. would be an investigative consumer report. (ii) consents orally or in writing to the making of the communication to a prospective employer. by using information in a consumer report on the consumer. not later than 3 business days after the receipt of the consent by that person. the Commonwealth of Puerto Rico. and any territory or possession of the United States. information in the consumer's application for the credit or insurance. for purposes of-(1) reviewing the account or insurance policy. (3) The consumer furnishing any collateral that is a requirement for the extension of the credit or insurance that was-(A) established before selection of the consumer for the offer of credit or insurance. make any inquiry that if made by a prospective employer of the consumer who is the subject of the communication would violate any applicable Federal or State equal employment opportunity law or regulation. or (B) of the information in the consumer's application for the credit or insurance.6604}} (1) that. (B) the person who makes the communication does not. and (B) disclosed to the consumer in the offer of credit or insurance. or (B) procuring an opportunity for a natural person to work for the employer. the nature and substance of all information in the consumer's file at the time of the request. not later than 5 business days after receiving any request from the consumer for such disclosure. (o) EXCLUDED COMMUNICATIONS. and (5) with respect to which-(A) the consumer who is the subject of the communication-(i) consents orally or in writing to the nature and scope of the communication. is provided written confirmation of that consent by the person making the communication. but for subsection (d)(2)(D). (4) that is not used by any person for any purpose other than a purpose described in subparagraph (A) or (B) of paragraph (2).201 (2) Verification-(A) that the consumer continues to meet the specific criteria used to select the consumer for the offer. (3) that is made by a person who regularly performs such procurement. for the purpose of making the communication. before the collection of any information for the purpose of making the communication. and (iii) in the case of consent under clause (i) or (ii) given orally. (n) STATE.{{4-30-99 p. or (2) collecting the account. 201 . and (C) the person who makes the communication-(i) discloses in writing to the consumer who is the subject of the communication.--The term "credit or insurance transaction that is not initiated by the consumer" does not include the use of a consumer report by a person with which the consumer has an account or insurance policy. or other information bearing on the credit worthiness or insurability of the consumer. to determine that the consumer meets the specific criteria bearing on credit worthiness or insurability.--The term "State" means any State. before the making of the communication. effective September 30.gov/regulations/laws/rules/10000-3. 104–208. No. 1970 (Pub. [Codified to 15 U. in writing. L. as added by section 601 of title VI of the Act of October 26.202 except that the sources of any information that is acquired solely for use in making the communication and is actually used for no other purpose. 3211). and to promote consistent State action to protect consumers against debt collection abuses The following section is an excerpt of text of the Fair Debt Collection Practices Act. 1999 . 84 Stat. for the purpose of furnishing consumer reports to third parties bearing on a consumer's credit worthiness. 1998 (Pub. (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 23.) Use this generic site 23. 110 Stat. 1968 (Pub. or a subpoena issued in connection with proceedings before a Federal grand jury. 1681a] [Source: Section 603 of title VI of the Act of May 29. effective September 30. credit standing. effective April 25. Fair Debt Collection Practices Act .fdic. 3009–426–430). 112 Stat.html.S. (2) In accordance with the written instructions of the consumer to whom it relates. Permissible purposes of reports (a) IN GENERAL.--The term "consumer reporting agency that compiles and maintains files on consumers on a nationwide basis" means a consumer reporting agency that regularly engages in the practice of assembling or evaluating. section 6(1)–(3) of the Act of November 2. No. 90–321). or credit capacity. 202 . and maintaining. 1128).purpose is to eliminate abusive debt collection practices by debt collectors. 1997] § 604. L. (p) CONSUMER REPORTING AGENCY THAT COMPILES AND MAINTAINS FILES ON CONSUMERS ON A NATIONWIDE BASIS. No. 1996 (Pub. L.C. 105–347. No.--Subject to subsection (c). to insure that those debt collectors who refrain from using abusive debt collection practices are not competitively disadvantaged. section 2402 of title II of the Act of September 30. any consumer reporting agency may furnish a consumer report under the following circumstances and no other: (1) In response to the order of a court having jurisdiction to issue such an order.http://www. 91–508. and (ii) notifies the consumer who is the subject of the communication. 1971. L. need not be disclosed other than under appropriate discovery procedures in any court of competent jurisdiction in which an action is brought. 1997. (2) Credit account information from persons who furnish that information regularly and in the ordinary course of business. each of the following regarding consumers residing nationwide: (1) Public record information. of the consumer's right to request the information described in clause (i). No. religion. 874). to marital instability. 1968 (Pub. 1978] § 802. No. or otherwise make unavailable or deny. Findings and purpose (a) There is abundant evidence of the use of abusive. [Codified to 15 U. 90--321). 1601 note] [Source: Section 801 of title VIII of the Act of May 29. religion.gov/regulations/laws/rules/8000-7.html#8284 24. and to promote consistent State action to protect consumers against debt collection abuses.purpose is to reduce discrimination in housing procurement. {{8-29-86 p. to insure that those debt collectors who refrain from using abusive debt collection practices are not competitively disadvantaged. effective March 20. a dwelling to any person because of race. familial status. Even where abusive debt collection practices are purely intrastate in character. Short title This title may be cited as the "Fair Debt Collection Practices Act". sex.http://www. DISCRIMINATION IN THE SALE OR RENTAL OF HOUSING AND OTHER PROHIBITED PRACTICES 203 . 1999 . and unfair debt collection practices by many debt collectors. Abusive debt collection practices contribute to the number of personal bankruptcies.fdic. 1977 (Pub. 1692] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 21.S. (b) Existing laws and procedures for redressing these injuries are inadequate to protect consumers.C. deceptive. color. they nevertheless directly affect interstate commerce. color. as added by the Act of September 20. to the loss of jobs. or to refuse to negotiate for the sale or rental of. or national origin. It is unlawful to: • refuse to sell or rent after the making of a bona fide offer. L.6617}} (e) It is the purpose of this title to eliminate abusive debt collection practices by debt collectors. Fair Housing Act . (c) Means other than misrepresentation or other abusive debt collection practices are available for the effective collection of debts. or in the provision of services or facilities in connection therewith. or national origin. [Codified to 15 U. The following section is an excerpt of text of the Fair Housing Act.S. familial status. conditions. and to invasions of individual privacy. sex. because of race. or privileges of sale or rental of a dwelling.C. 95--109. • (b) To discriminate against any person in the terms. (d) Abusive debt collection practices are carried on to a substantial extent in interstate commerce and through means and instrumentalities of such commerce.203 § 801. L. 91 Stat. or discrimination based on race. or services. color. familial status. (e) For profit. or an intention to make any such preference. (b) To discriminate against any person in the terms. to induce or attempt to induce any person to sell or rent any dwelling by representations regarding the entry or prospective entry into the neighborhood of a person or persons of a particular race. familial status. because of a handicap of-(A) that person. conditions. or (C) in connection with the design and construction of covered multifamily dwellings for first occupancy after the date that is 30 months after the date of enactment of the Fair Housing Amendments Act of 1988. or made available. or privileges of sale or rental of a dwelling. religion. 204 . printed. color. conditions. handicap. with respect to the sale or rental of a dwelling that indicates any preference. or national origin. rented. color. 804. familial status. or to refuse to negotiate for the sale or rental of. it shall be unlawful-(a) to refuse to sell or rent after the making of a bona fide offer. at the expense of the handicapped person. or to otherwise make unavailable or deny. or privileges of sale or rental of a dwelling. discrimination includes-(A) a refusal to permit. or cause to be made. sex. sex. or in the provision of services or facilities in connection with such dwelling. (B) a person residing in or intending to reside in that dwelling after it is so sold.204 SEC. or (C) any person associated with that buyer or renter. limitation. (d) To represent to any person because of race. sale. sex. or national origin. or national origin that any dwelling is not available for inspection. rented. handicap. or (B) a person residing in or intending to reside in that dwelling after it is so sold. policies. or national origin. print. handicap. religion.8204}} (f)(1) To discriminate in the sale or rental. (3) For purposes of this subsection. or made available. or in the provision of services or facilities in connection therewith. reasonable modifications of existing premises occupied or to be occupied by such person if such modifications may be necessary to afford such person full enjoyment of the premises. when such accommodations may be necessary to afford such person equal opportunity to use and enjoy a dwelling. statement. a dwelling to any person because of race. sex. or discrimination. sex. familial status. religion. or published any notice. As made applicable by section 803 and except as exempted by sections 803(b) and 807. limitation. or rental when such dwelling is in fact so available. practices. or publish. or national origin. (B) a refusal to make reasonable accommodations in rules. color. (2) To discriminate against any person in the terms. or (C) any person associated with that person. because of race. religion. color. {{10-31-88 p. (c) To make. a dwelling to any buyer or renter because of a handicap of-(A) that buyer or renter. or advertisement. religion. or otherwise make unavailable or deny. familial status. a failure to design and construct those dwellings in such a manner that-(i) the public use and common use portions of such dwellings are readily accessible to and usable by handicapped persons. (II) light switches.205 (ii) all the doors designed to allow passage into and within all premises within such dwellings are sufficiently wide to allow passage by handicapped persons in wheelchairs. {{10-31-88 p. (6)(A) Nothing in paragraph (5) shall be construed to affect the authority and responsibility of the Secretary or a State or local public agency certified pursuant to section 810(f)(3) of this Act to receive and process complaints or otherwise engage in enforcement activities under this title. but may not require. and other environmental controls in accessible locations. designs or construction of all covered multifamily dwellings. (4) Compliance with the appropriate requirements of the American National Standard for buildings and facilities providing accessibility and usability for physically handicapped people (commonly cited as "ANSI A117. and shall provide technical assistance to States and units of local government and other persons to implement the requirements of paragraph (3)(C). (C) The Secretary shall encourage.1") suffices to satisfy the requirements of paragraph (3)(C)(iii). or other jurisdiction in which this title shall be effective. (B) A State or unit of general local government may review and approve newly constructed covered multifamily dwellings for the purpose of making determinations as to whether the design and construction requirements of paragraph (3)(C) are met. electrical outlets. the term "covered multifamily dwellings" means-(A) buildings consisting of 4 or more units if such buildings have one or more elevators. (III) reinforcements in bathroom walls to allow later installation of grab bars. (5)(A) If a State or unit of general local government has incorporated into its laws the requirements set forth in paragraph (3)(C). to determine whether the design and construction of such dwellings are consistent with the requirements of paragraph 3(C). (7) As used in this subsection. 205 . and (B) ground floor units in other buildings consisting of 4 or more units. (8) Nothing in this title shall be construed to invalidate or limit any law of a State or political subdivision of a State.8205}} (D) Nothing in this title shall be construed to require the Secretary to review or approve the plans. and (iii) all premises within such dwellings contain the following features of adaptive design: (I) an accessible route into and through the dwelling. (B) Determinations by a State or a unit of general local government under paragraphs (5) (A) and (B) shall not be conclusive in enforcement proceedings under this title. and (IV) usable kitchens and bathrooms such that an individual in a wheelchair can maneuver about the space. that requires dwellings to be designed and constructed in a manner that affords handicapped persons greater access than is required by this title. thermostats. compliance with such laws shall be deemed to satisfy the requirements of that paragraph. States and units of local government to include in their existing procedures for the review and approval of newly constructed covered multifamily dwellings. determinations as to whether the design and construction of such dwellings are consistent with paragraph (3)(C). 3605] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 21.S. FUNCTIONS OF APPRAISAL SUBCOMMITTEE. or (B) secured by residential real estate. and for other purposes.C. FINANCIAL INSTITUTIONS REFORM. Recovery and Enforcement Act (FIRREA) . Recovery and Enforcement Act. or appraising of residential real property. improving. handicap. religion. color. SEC. recapitalize. sex. to enhance the regulatory and enforcement powers of Federal financial institutions regulatory agencies.C. 1999 .--Nothing in this title prohibits a person engaged in the business of furnishing appraisals of real property to take into consideration factors other than race. 3604] [Codified to 42 U.206 (9) Nothing in this subsection requires that a dwelling be made available to an individual whose tenancy would constitute a direct threat to the health or safety of other individuals or whose tenancy would result in substantial physical damage to the property of others. familial status. national origin.--As used in this section. repairing. sex. or maintaining a dwelling. brokering. RECOVERY AND ENFORCEMENT ACT OF 1989 To reform. [Codified to 42 U.html#8284 25. The following section is an excerpt of text of the Financial Institution Reform.purpose is to reform. (a) IN GENERAL. religion. or in the terms or conditions of such a transaction. (a) IN GENERAL.fdic.S.gov/regulations/laws/rules/8000-7. color. 1103. 206 . or national origin. including a code of professional responsibility. recapitalize.--It shall be unlawful for any person or other entity whose business includes engaging in residential real estate-related transactions to discriminate against any person in making available such a transaction. and consolidate the Federal deposit insurance system.http://www.C. (2) The selling.--The Appraisal Subcommittee shall-(1) monitor the requirements established by States for the certification and licensing of individuals who are qualified to perform appraisals in connection with federally related transactions. or familial status. (c) APPRAISAL EXEMPTION. the term "residential real estate-related transaction" means any of the following: (1) The making or purchasing of loans or providing other financial assistance-(A) for purchasing. handicap. [Codified to 42 U. and consolidate the Federal deposit insurance system. because of race.S. to enhance the regulatory and enforcement powers of Federal financial institutions regulatory agencies. constructing. 805. (b) DEFINITION. 3601 note] SEC. Financial Institution Reform. SHORT TITLE. and organizational structure of the Appraisal Foundation.fdic.--The Appraisal Subcommittee shall monitor and review the practices. 102--242. to provide additional resources to the Bank Insurance Fund The following section is an excerpt of text of the FDIC Improvement Act of 1991. to improve supervision and examinations. This Act may be cited as the "Federal Deposit Insurance Corporation Improvement Act of 1991".S. 105 Stat. [Codified to 12 U. to improve supervision and examinations. 3332] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 21.purpose is to require the least-cost resolution of insured depository institutions.C. and (4) transmit an annual report to the Congress not later than January 31 of each year which describes the manner in which each function assigned to the Appraisal Subcommittee has been carried out during the preceding year.gov/regulations/laws/rules/8000-7.207 (2) monitor the requirements established by the Federal financial institutions regulatory agencies and the Resolution Trust Corporation with respect to-(A) appraisal standards for federally related transactions under their jurisdiction. and for other purposes. Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled. FDIC Improvement Act of 1991 . procedures. SECTION 1. No.html#8284 26. 1811 note] [Source: Section 1 of the Act of December 19. activities. (b) MONITORING AND REVIEWING FOUNDATION.http://www. L. effective December 19. 1991] TITLE I--SAFETY AND SOUNDNESS Subtitle B--Supervisory Reforms 207 . and (B) determinations as to which federally related transactions under their jurisdiction require the services of a State certified appraiser and which require the services of a State licensed appraiser. [Codified to 12 U. to provide additional resources to the Bank Insurance Fund.S. 2236).C. (3) maintain a national registry of State certified and licensed appraisers who are eligible to perform appraisals in federally related transactions. FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991 To require the least-cost resolution of insured depository institutions. 1991 (Pub. 1999 . -(1) IN GENERAL. acting through the Federal Financial Institutions Examination Council. 3305 note] {2-28-92 p. a full-scope. under the program. (2) REQUIREMENTS. supervisors. 111. (c) TRANSITION RULE. 1991 (Pub. 1993. during the period beginning on the date of enactment of this Act and ending on December 31.S. No. (a) IN GENERAL. 102--242.8550} [Source: Section 111(d) of title I of the Act of December 19. 1991] (d) EXAMINATION IMPROVEMENT PROGRAM.--An examination improvement program meets the requirements of this paragraph if. 1991] Subtitle C--Accounting Reforms SEC. the agency is required-(A) to periodically review the organization and training of the staff of the agency who are responsible for conducting examinations of insured depository institutions and to make such improvements as the agency determines to be appropriate to ensure frequent. 102--242. 1991 (Pub.208 SEC. and thorough examinations of such institutions. when most recently examined. 1820 note] [Source: Section 111(c) of title I of the Act of December 19. on-site examination of an insured depository institution is not required more often than once during every 18-month period. shall each establish a comparable examination improvement program that meets the requirements of paragraph (2). objective. effective December 19. SMALL BUSINESS AND SMALL FARM LOAN INFORMATION. 105 Stat. [Codified to 12 U. and (B) to increase the number of examiners.--Before the end of the 180-day period beginning on the date of the enactment of this Act. the appropriate Federal banking agency shall prescribe regulations requiring insured depository institutions to annually submit information on small businesses and small farm lending in their reports of condition.S. 105 Stat. [Codified to 12 U. or (2) 1 or more persons acquired control of the institution.C. 208 .--The appropriate Federal banking agencies. 122. L.--Notwithstanding section 10(d) of the Federal Deposit Insurance Act (as added by subsection (a)). No. objective.C. 2241). unless-(1) the institution. effective December 19. IMPROVED EXAMINATIONS. and thorough examinations of such institutions. 2241). and other individuals employed by the agency in connection with conducting or supervising examinations of insured depository institutions to the extent necessary to ensure frequent. L. was found to be in a less than satisfactory condition. 2251). effective December 19. L. No.--It is the sense of the Congress that the Federal banking agencies should facilitate early resolution of troubled insured depository institutions whenever feasible if early resolution would have the least possible long-term cost to the deposit insurance fund. 1991] Subtitle E--Least-Cost Resolution SEC. effective December 19. L. effective December 19.--The regulations prescribed under subsection (a) shall require insured depository institutions to submit such information as the agency may need to assess the availability of credit to small businesses and small farms. 1991 (Pub. 102--242.C. 105 Stat. 1817 note] [Source: Section 122(b) of title I of the Act of December 19.S. [Codified to 12 U. effective December 19.8550. 102--242. the Congress contemplates that any resolution transaction under section 13(c) of that Act would observe the following general principles: 209 . 1991 (Pub.01}} (b) GENERAL PRINCIPLES. 1817 note] [Source: Section 122(a) of title I of the Act of December 19.C. 102--242.S. No. 143.--The information required under subsection (a) may include information regarding the following: (1) The total number and aggregate dollar amount of commercial loans and commercial mortgage loans to small businesses. [Codified to 12 U. 105 Stat. 1823 note] [Source: Section 143(a) of title I of the Act of December 19. (2) Charge-offs. No. 105 Stat. 1817 note] [Source: Section 122(d) of title I of the Act of December 19. 1991] (b) CREDIT AVAILABILITY. 2251). 1991] (d) CONTENTS.C.C. 105 Stat. (a) IN GENERAL. EARLY RESOLUTION. consistent with the least-cost and prompt corrective action provisions of the Federal Deposit Insurance Act. No. (3) Agricultural loans to small farms. interest. 1991] {{2-28-92 p. 1991 (Pub. 2281). [Codified to 12 U. 2251).--In encouraging the Federal banking agencies to pursue early resolution strategies.209 [Codified to 12 U. L. and interest fee income on commercial loans and commercial mortgage loans to small businesses. 102--242. 1991 (Pub.S. L.S. C. [Codified to 12 U. and (B) new investors share risk with the Corporation. taking into account the value of expediting the process. 1991 (Pub. (6) FDIC'S PARTICIPATION.--Preexisting owners and debtholders of any troubled institution or its holding company should make substantial concessions. (2) RESULTING INSTITUTION ADEQUATELY CAPITALIZED. 2282). effective December 19. (4) CONCESSIONS.--Two years after the date of enactment of this Act. No.--The transaction should give the Federal Deposit Insurance Corporation an opportunity to participate in the success of the resulting institution. 1991] (c) REPORT. SHORT TITLE. be structured so that-(A) the Federal Deposit Insurance Corporation-(i) does not acquire a significant proportion of the troubled institution's problem assets. and (iii) limits the Corporation's assistance in term and amount. 102--242. and should not include individuals substantially responsible for the troubled institution's problems. 105 Stat. 201.--The transaction should be negotiated competitively.C. the Federal Deposit Insurance Corporation shall submit a report to Congress analyzing the effect of early resolution on the deposit insurance funds. insofar as practical. 1991] TITLE II--REGULATORY IMPROVEMENT Subtitle A--Regulation of Foreign Banks SEC.S. 3101 note] 210 .--The transaction should involve substantial private investment. 1823 note] [Source: Section 143(c) of title I of the Act of December 19. This subtitle may be cited as the "Foreign Bank Supervision Enhancement Act of 1991". 1823 note] [Source: Section 143(b) of title I of the Act of December 19.C. 1991 (Pub. 2281). 102--242. L. effective December 19. (ii) succeeds to the interests of the troubled institution's preexisting owners and debtholders in proportion to the assistance the Corporation provides. 105 Stat.--The transaction should.S.S. (5) QUALIFIED MANAGEMENT. (3) SUBSTANTIAL PRIVATE INVESTMENT.--Any insured depository institution created or assisted in the transaction (hereafter the "resulting institution") and any institution acquiring the troubled institution should meet all applicable minimum capital standards. [Codified to 12 U. No. L. (7) STRUCTURE OF TRANSACTION. [Codified to 12 U.210 (1) COMPETITIVE NEGOTIATION.--Directors and senior management of the resulting institution should be qualified to perform their duties. 105 Stat. Foreign Corrupt Practices Act .http://www. 102--242. effective December 19. The Act includes civil and criminal penalties and applies to the person giving the bribe rather than the recipient of the bribe. to make use of the mails or any means or instrumentality of interstate commerce corruptly in furtherance of an offer. or candidate to do or omit to {{2-26-99 p. promise to pay. or (iii) securing any improper advantage. 1496). or 211 . (ii) inducing such foreign official to do or omit to do any act in violation of the lawful duty of such official. or directing business to. any person. (ii) inducing such party.--It shall be unlawful for any domestic concern. director. 1977. L.html. The following section is an excerpt of text of the Foreign Corrupt Practices Act. or authorization of the giving of anything of value to-(1) any foreign official for purposes of-(A)(i) influencing any act or decision of such foreign official in his official capacity. The primary purpose is to prevent the misrepresentation of accounting and business records to permit financial gains through questionable or illegal payments. L. in order to assist such domestic concern in obtaining or retaining business for or with. or candidate to use its or his influence with a foreign government or instrumentality thereof to affect or influence any act or decision of such government or instrumentality. or candidate. official. reads as follows: PROHIBITED FOREIGN TRADEPRACTICES BY DOMESTIC CONCERNS SEC. employee. Foreign corrupt practices by domestic concerns. No. other than an issuer which is subject to section 30A of the Securities Exchange Act of 1934. in order to assist such domestic concern in obtaining or retaining business for or with. 1991 (Pub. or (B) inducing such party.gov/regulations/laws/rules/10000-3. 1977 (Pub. No. official. 1999 . or (iii) securing any improper advantage. gift. 2286). 95--213. or authorization of the payment of any money.fdic. 104. effective December 19.The Foreign Corrupt Practices Act was added to the Securities and Exchange of 1934 in 1977. or (B) inducing such foreign official to use his influence with a foreign government or instrumentality thereof to affect or influence any act or decision of such government or instrumentality. (2) any foreign political party or official thereof or any candidate for foreign political office for purposes of-(A)(i) influencing any act or decision of such party. (a) PROHIBITION. payment. or directing business to. official.) 27. Detailed record requirements are imposed to prevent the bribery of foreign officials for financial gain. or agent of such domestic concern or any stockholder thereof acting on behalf of such domestic concern. 1991] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 23. any person. 91 Stat. promise to give.9263}}do an act in violation of the lawful duty of such party. or any officer. or candidate in its or his official capacity.211 [Source: Section 201 of title II of the Act of December 19. official. or offer. Section 104 of title I of the Act of December 19. or candidate to do or omit to do any act in violation of the lawful duty of such foreign official. party official. or any territory. or other documents which the Attorney General deems relevant or material to such investigation. or about to engage. political party. any person. is engaged. gift.--(1) When it appears to the Attorney General that any domestic concern to which this section applies. was a reasonable and bona fide expenditure. or stockholder thereof. party official. given. a permanent injunction or a temporary restraining order shall be granted without bond. or directing business to. party. subpoena witnesses. for purposes of-(A)(i) influencing any act or decision of such foreign official. or candidate. political party. party official's. any person. or to any candidate for foreign political office. directly or indirectly. or candidate and was directly related to-(A) the promotion. political party. the Attorney General or his designee are empowered to administer oaths and affirmations. or explanation of products or services. in his discretion. party official.212 (3) any person. or promise of anything of value that was made. or candidate's country. or (iii) securing any improper advantage. political party's. (d) INJUNCTIVE RELIEF. or party official. was lawful under the written laws and regulations of the foreign official's. in the opinion of the Attorney General. (3) In case of contumacy by. bring a civil action in an appropriate district court of the United States to enjoin such act or practice.--It shall be an affirmative defense to actions under subsections (a) and (i) that-(1) the payment. to any foreign official. (c) AFFIRMATIVE DEFENSES. in order to assist such domestic concern in obtaining or retaining business for or with. such as travel and lodging expenses. demonstration. while knowing that all or a portion of such money or thing of value will be offered. director. offer. in any act or practice constituting a violation of subsections (a) and (i) of this section. political party. to any foreign political party or official thereof. and require the production of any books. or (2) the payment. or candidate to use his or its influence with a foreign government or instrumentality thereof to affect or influence any act or decision of such government or instrumentality. gift. or refusal to obey a subpoena issued to. or (B) inducing such foreign official.--Subsections (a) and (i) shall not apply to any facilitating or expediting payment to a foreign official. and upon a proper showing. take evidence. (2) For the purpose of any civil investigation which. or promise of anything of value that was made. is necessary and proper to enforce this section. party official. agent. possession. political party. papers. party official. or candidate in his or its official capacity. at any designated place of hearing. offer. political party. or party official the purpose of which is to expedite or to secure the performance of a routine governmental action by a foreign official. (ii) inducing such foreign official. or (B) the execution or performance of a contract with a foreign government or agency thereof. employee. or commonwealth of the United States. or officer. the Attorney General may. (b) EXCEPTION FOR ROUTINE GOVERNMENTAL ACTION. or promised. incurred by or on behalf of a foreign official. the Attorney General may invoke the aid of any court of the United States within the jurisdiction 212 . The attendance of witnesses and the production of documentary evidence may be required from any place in the United States. within 30 days after receiving such a request. and the Secretary of the Treasury. and after obtaining the views of all interested persons through public notice and comment procedures. papers. The Attorney General may make such rules relating to civil investigations as may be necessary or appropriate to implement the provisions of this subsection. there to produce {{2-26-99 p. or to give testimony touching the matter under investigation. The Attorney General shall issue the guidelines and procedures referred to in the preceding sentence in accordance with the provisions of subchapter II of chapter 5 of title 5. if so ordered. the United States Trade Representative. and those guidelines and procedures shall be subject to the provisions of chapter 7 of that title. (f) OPINIONS OF THE ATTORNEY GENERAL. the Attorney General determines would be in conformance with the preceding provisions of this section. there shall be a rebuttable presumption that conduct. Any such court may issue an order requiring such person to appear before the Attorney General or his designee. In any action brought under the applicable provisions of this section. in requiring the attendance and testimony of witnesses and the production of books. shall determine to what extent compliance with this section would be enhanced and the business community would be assisted by further clarification of the preceding provisions of this section and may. The opinion shall state whether or not certain specified prospective conduct would. issue an opinion in response to that request. (e) GUIDELINES BY THE ATTORNEY GENERAL. which for purposes of the Department of Justice's present enforcement policy. The Attorney General shall.--Not later than 6 months after the date of the enactment of the Foreign Corrupt Practices Act Amendments of 1988. Additional requests for opinions may be filed with the Attorney General regarding other specified prospective conduct that is beyond the scope of conduct specified in previous requests. United States Code. and (2) general precautionary procedures which domestic concerns may use on a voluntary basis to conform their conduct to the Department of Justice's present enforcement policy regarding the preceding provisions of this section. the Attorney General.213 of which such investigation or proceeding is carried on. for purposes of the Department of Justice's present enforcement policy. associated with common types of export sales arrangements and business contracts. after consultation with the Securities and Exchange Commission. or where such person resides or carries on business. based on such determination and to the extent necessary and appropriate. All process in any such case may be served in the judicial district in which such person resides or may be found. or other documents.--(1) The Attorney General. the Secretary of State. shall establish a procedure to provide responses to specific inquiries by domestic concerns concerning conformance of their conduct with the Department of Justice's present enforcement policy regarding the preceding provisions of this section. issue-(1) guidelines describing specific types of conduct. violate the preceding provisions of this section. Any failure to obey such order of the court may be punished by such court as a contempt thereof.9264}}records. which is specified in a request by a domestic concern and for which the Attorney General has issued an opinion that such conduct is in conformity with the 213 . the Secretary Commerce. after consultation with appropriate departments and agencies of the United States and after obtaining the views of all interested persons through public notice and comment procedures. The Attorney General shall establish the procedure required by this paragraph in accordance with the provisions of subchapter II of chapter 5 of title 5. director.214 Department of Justice's present enforcement policy. (g) PENALTIES.000 imposed in an action brought by the Attorney General. provide timely guidance concerning the Department of Justice's present enforcement policy with respect to the preceding provisions of this section to potential exporters and small businesses that are unable to obtain specialized counsel on issues pertaining to such provisions. United States Code. or stockholder acting on behalf of such domestic concern).000. shall be fined not more than $100.000. (C) Any officer. or stockholder acting on behalf of such domestic concern. employee. including but not limited to whether the information submitted to the Attorney General was accurate and complete and whether it was within the scope of the conduct specified in any request received by the Attorney General.000. who violates subsection (a) shall be subject to a civil penalty of not more than $10. who willfully violates subsection (a) shall be fined not more than $100. (2)(A) Any natural person that is an officer. (2) Any document or other material which is provided to.9265}}be made publicly available. (B) Any employee or agent of a domestic concern who is a United States citizen. shall be exempt from disclosure under section 552 of title 5. national. (4) The Attorney General shall. and that procedure shall be subject to the provisions of chapter 7 of that title. a court shall weigh all relevant factors. (B) Any domestic concern that violates subsection (a) shall be subject to a civil penalty of not more than $10. is in compliance with the preceding provisions of this section. or imprisoned not more than 5 years. Such guidance shall be limited to responses to requests under paragraph (1) concerning conformity of specified prospective conduct with the Department of Justice's present enforcement policy regarding the preceding provisions of this section and general explanations of compliance responsibilities and of potential liabilities under the preceding provisions of this section.000 imposed in an action brought by the Attorney General. or resident or is otherwise subject to the jurisdiction of the United States (other than an officer. to the maximum extent practicable. Such a presumption may be rebutted by a preponderance of the evidence. United States Code. and shall not. employee. director. except with the consent of the domestic concern. {{2-26-99 p. or both. and who willfully violates subsection (a). or prepared in the Department of Justice or any other department or agency of the United States in connection with a request by a domestic concern under the procedure established under paragraph (1). or imprisoned not more than 5 years. regardless of whether the Attorney General responds to such a request or the domestic concern withdraws such request before receiving a response. or stockholder acting on behalf of such domestic concern. or agent of a domestic concern.--(1)(A) Any domestic concern that is not a natural person and that violates subsections (a) and (i) of this section shall be fined not more than $2. or both. received by. 214 . (3) Any domestic concern who has made a request to the Attorney General under paragraph (1) may withdraw such request prior to the time the Attorney General issues an opinion in response to such request.000. In considering the presumption for purposes of this paragraph. or agent of a domestic concern. director. Any request so withdrawn shall have no force or effect. or (v) actions of a similar nature. or stockholder of a domestic concern. or instrumentality. mail pick-up and delivery. director. or (ii) such person has a firm belief that such circumstance exists or that such result is substantially certain to occur. that such circumstance exists. agency. partnership. loading and unloading cargo. or of a public international organization. (B) When knowledge of the existence of a particular circumstance is required for an offense. or instrumentality thereof.C. or a result if-(i) such person is aware that such person is engaging in such conduct. or resident of the United States. a circumstance. association. such fine may not be paid. or sole proprietorship which has its principal place of business in the United States. (B) For purposes of subparagraph (A). national. (iv) providing phone service. (B) The term "routine governmental action" does not include any decision by a foreign official whether. by such domestic concern. such knowledge is established if a person is aware of a high probability of the existence of such circumstance. (2)(A) The term "foreign official" means any officer or employee of a foreign government or any department. power and water supply. or (ii) any other international organization that is designated by the President by Executive order for the purposes of this section. (4)(A) The term "routine governmental action" means only an action which is ordinarily and commonly performed by a foreign official in-(i) obtaining permits. the term "public international organization" means-(i) an organization that is designated by Executive order pursuant to section 1 of the International Organizations Immunities Act (22 U. joint-stock company. and (B) any corporation. or scheduling inspections associated with contract performance or inspections related to transit of goods across country. agent. directly or indirectly. or other official documents to qualify a person to do business in a foreign country. or for or on behalf of any such public international organization.9266}}result is substantially certain to occur. (iii) providing police protection. (3)(A) A person's state of mind is "knowing" with respect to conduct. (ii) processing governmental papers. 288). (h) DEFINITIONS. business trust. or that such {{2-26-99 p.--For purposes of this section: (1) The term "domestic concern" means-(A) any individual who is a citizen. or commonwealth of the United States.S. or any person acting in an official capacity for or on behalf of any such government or department. unless the person actually believes that such circumstance does not exist. licenses. or protecting perishable products or commodities from deterioration. effective as of the date of publication of such order in the Federal Register. such as visas and work orders. or on what terms.215 (3) Whenever a fine is imposed under paragraph (2) upon any officer. employee. possession. or which is organized under the laws of a State of the United States or a territory. agency. to award new business to or to continue business with a 215 . unincorporated organization. or communication among the several States.http://www. partnership. No. L. 103– 322. possession. 1496). (2). effective August 23. effective December 19. 1419–1424).C. or commonwealth of the United States. unincorporated organization. 1998 (Pub. (5) The term "interstate commerce" means trade. payment. joint-stock company. employee. agent. effective September 13. association. 1977.-(1) It shall also be unlawful for any issuer organized under the laws of the United States. territory. 105–366.S. 1988 (Pub. [Codified to 15 U. or agent of such issuer or a stockholder thereof acting on behalf of such issuer. director. No.Congress found that (1) from time to time flood disasters have created personal hardships and economic distress which have required unforeseen disaster relief measures and have placed an increasing burden on the Nation's 216 . commerce. territory. 1977 (Pub. 1101)) or any corporation. or any political subdivision thereof. promise to give. 102 Stat. 3304 and 3305).) 28. irrespective of whether such issuer or such officer. 91 Stat. (2) As used in this subsection. L. 1994 (Pub. and such term includes the intrastate use of-(A) a telephone or other interstate means of communication. to corruptly do any act outside the United States in furtherance of an offer. 108 Stat. or stockholder makes use of the mails or any means or instrumentality of interstate commerce in furtherance of such offer. or any action taken by a foreign official involved in the decision-making process to encourage a decision to award new business to or continue business with a particular party. 78dd–2] [Source: Section 104 of title I of the Act of December 19. L. or for any United States person that is an officer.S. promise to pay. or between any foreign country and any State or between any State and any place or ship outside thereof. National Flood Insurance Program . or authorization of the giving of anything of value to any of the persons or entities set forth in paragraphs (1). effective November 10. as amended by section 5003(c) of title V of the Act of August 23. gift. or offer. transportation. or commonwealth of the United States or a political subdivision thereof and which has a class of securities registered pursuant to section 12 of this title or which is required to file reports under section 15(d) of this title. or sole proprietorship organized under the laws of the United States or any State. payment. (g) ALTERNATIVE JURISDICTION. promise.gov/regulations/laws/rules/10000-3.fdic. or authorization of the payment of any money. No. and (3) of subsection (a) of this section for the purposes set forth therein. gift. 1988. 112 Stat. or (B) any other interstate instrumentality. 2142). or authorization. 1998] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 23. business trust. 1999 .216 particular party.html. possession. section 330005 of title XXXIII of the Act of September 13. No. 1994. L.C. 95–213. director. 100–418. sections 3(a)–3(e) of the Act of November 10. employee. the term "United States person" means a national of the United States (as defined in section 101 of the Immigration and Nationality Act (8 U. or a State. 217 resources. and (4) if such a program is initiated and carried out gradually. (2) despite the installation of preventive and protective works and the adoption of other public programs designed to reduce losses caused by flood damage. No.000 aggregate liability for any singlefamily dwelling. the limits provided in clause (i) of this sentence shall be: $50. (ii) $10.000 for any residential structure containing more than one dwelling unit.C. and in the Virgin Islands and Guam. a reasonable method of sharing the risk of flood losses is through a program of flood insurance which can complement and encourage preventive and protective measures. including any contents thereof related to premises of small business occupants (as that term is defined by 217 . Text above is from http://www4. 1301. and $150. and $100. 1968] NATURE AND LIMITATION OF INSURANCE COVERAGE SEC. it can be expanded as knowledge is gained and experience is appraised. TITLE XIII--NATIONAL FLOOD INSURANCE SHORT TITLE Sec. an aggregate liability with respect to any single structure. 1968 (Pub.cornell. This title may be cited as the "National Flood Insurance Act of 1968". (3) as a matter of national policy.law.html on January 2. 4001] [Source: Section 1301 of title XIII of the Act of August 1.--In addition to any other terms and conditions under subsection (a) of this section.000 aggregate liability per dwelling unit for any contents related to such unit.edu/uscode/42/4001. L.S. [Codified to 42 U.000 for any residential structure containing more than one dwelling unit. 2000. 90--448. 570). thus eventually making flood insurance coverage available on reasonable terms and conditions to persons who have need for such protection. such regulations shall provide that-(1) any flood insurance coverage based on chargeable premium rates under section 4015 of this title which are less than the estimated premium rates under section 4014(a)(1) of this title shall not exceed-(A) in the case of residential properties-(i) $35. these methods have not been sufficient to protect adequately against growing exposure to future flood losses. 82 Stat. 1306 (b) REGULATIONS RESPECTING AMOUNT OF COVERAGE. and (iii) in the States of Alaska and Hawaii.000 aggregate liability for any single-family dwelling. The following section is an excerpt of text of the National Flood Insurance Program. (B) in the case of business properties which are owned or leased and operated by small business concerns. effective August 1. and the amount of such excess coverage shall not in any case exceed an amount equal to the applicable limit so specified (or allocated) under paragraph (1)(C). or (4). L. 98--181.000 for any contents related to each structure. 1994] 218 .C. L. 97 Stat.218 the Director). L. amended by section 2(c)(2) of the Act of December 22. L. 85 Stat. (3). in respect to any single structure. 1994 (Pub. and (C) in the case of church properties and any other properties which may become eligible for flood insurance under section 1305-(i) $100. 1971 (Pub. 103-325. (B). additional flood insurance in excess of the limits specified in clause (ii) of subparagraph (A) of paragraph (1) shall be made available to every insured upon renewal and every applicant for insurance so as to enable any such insured or applicant to receive coverage up to a total amount (including such limits specified in paragraph (1)(A)(ii)) of $100. 1229). 91 Stat. [Codified to 42 U. L. section 527 of title V of the Act of September 23. 977). section 101 of Title I of the Act of December 31. 93--234.000 multiplied by the number of such occupants and shall be allocated among such occupants (or among the occupant or occupants and the owner) under regulations prescribed by the Director.000. effective October 12. 108 Stat. 1971. 92--213.000 aggregate liability for any single structure.000. No. 82 Stat. No. 1973 (Pub. effective September 23. additional flood insurance in excess of the limits specified in subparagraphs (B) and (C) of paragraph (1) shall be made available to every insured upon renewal and every applicant for insurance. L. 1977 (Pub. additional flood insurance in excess of the limits specified in clause (i) of subparagraph (A) of paragraph (1) shall be made available to every insured upon renewal and every applicant for insurance so as to enable such insured or applicant to receive coverage up to a total amount (including such limits specified in paragraph (1)(A)(i)) of $250.000. 775). 1983 (Pub. section 704(a) of title VII of the Act of October 12. {{10-31-94 p. including churches. or (C) of paragraph (1).000 aggregate liability per unit for any contents related to such unit. effective December 31. 1973. shall be based only on chargeable premium rates under section 4015 of this title which are not less than the estimated premium rates under section 4014(a)(1) of this title. 4013b] Source: Section 1306(b) of title XIII of the Act of August 1.000 plus (ii) $100. as applicable) of $500. 1983. (3) in the case of any residential property for which the risk premium rate is determined in accordance with the provisions of section 4014(a)(1) of this title. No.S. 95--128.000 for each structure and $500. and (2) in the case of any residential property for which the risk premium rate is determined in accordance with the provisions of section 4014(a)(1) of this title. effective November 30. 575). and (ii) $100. effective December 22. 87 Stat. which shall be equal to (i) $100. No. and (5) any flood insurance coverage which may be made available in excess of the limits specified in subparagraph (A). 90--448. for which the risk premium rate is determined in accordance with the provisions of section 1307(a)(1). 1968. section 451(d)(1) of title IV of the Act of November 30. except that the aggregate liability for the structure itself may in no case exceed $100. 2263). 1977. as applicable. No. effective August 1. up to a total amount (including such limit specified in subparagraph (B) or (C) of paragraph (1). 1145). 1968 (Pub. (2).8656}} (4) in the case of any nonresidential property. No. 1364. (a) NOTIFICATION OF SPECIAL FLOOD HAZARDS. and (D) any other information that the Director considers necessary to carry out the purposes of the national flood insurance program.--Each Federal agency lender shall by regulation provide for notification in the manner provided under paragraph (1) with respect to any loan 219 . renewing. a reasonable period in advance of the signing of the purchase agreement. (2) FEDERAL AGENCY LENDERS. (2) FEDERAL AGENCY LENDERS.--Written notification required under this subsection shall include-(A) a warning.219 NOTICE REQUIREMENTS SEC. the duty to provide notification under this subsection shall transfer to the transferee servicer of the loan. (3) CONTENTS OF NOTICE. to notify the Director (or the designee of the Director) in writing during the term of the loan of the servicer of the loan. in writing. stating that the building on the improved real estate securing the loan is located. The regulations under this subsection shall provide that upon any change in the servicing of a loan. not later than 60 days after the effective date of such change. selling. as a condition of making. to notify the purchaser or lessee (or obtain satisfactory assurances that the seller or lessor has notified the purchaser or lessee) and the servicer of the loan of such special flood hazards.--Each Federal entity for lending regulation (after consultation and coordination with the Financial Institutions Examination Council) shall by regulation require regulated lending institutions.--Each Federal entity for lending regulation (after consultation and coordination with the Financial Institutions Examination Council) shall by regulation require regulated lending institutions. in an area having special flood hazards.--Each Federal agency lender shall by regulation require notification in the manner provided under paragraph (1) with respect to any loan that is made by the Federal agency lender and secured by improved real estate or a mobile home located or to be located in an area that has been identified by the Director under this title or the Flood Disaster Protection Act of 1973 as an area having special flood hazards. in a form to be established by the Director. (C) a statement that flood insurance coverage may be purchased under the national flood insurance program and is also available from private insurers. (b) NOTIFICATION OF CHANGE OF SERVICER. increasing. or other documents involved in the transaction. Such institutions shall also notify the Director (or such designee) of any change in the servicer of the loan. extending.-(1) REGULATED LENDING INSTITUTIONS. extending. increasing. in connection with the making. Any regulations issued under this paragraph shall be consistent with and substantially identical to the regulations issued under paragraph (1). The regulations shall also require that the regulated lending institution retain a record of the receipt of the notices by the purchaser or lessee and the servicer.-(1) LENDING INSTITUTIONS. or renewing any loan secured by improved real estate or a mobile home that the regulated lending institution determines is located or is to be located in an area that has been identified by the Director under this title or the Flood Disaster Protection Act of 1973 as an area having special flood hazards. or the mobile home securing the loan is or is to be located. or transferring any loan described in subsection (a)(1). {{10-31-94 p.8657}} (B) a description of the flood insurance purchase requirements under section 102(b) of the Flood Disaster Protection Act of 1973. lease. effective August 22.html. 1999 http://www. No. No. and accurate information regarding settlement costs. L. 1968. to impose controls on transactions and freeze foreign assets under U. 103--325. 739). 1974 (Pub. are multilateral in scope. effective August 1. as well as authority granted by specific legislation. 4104a] [Source: Section 1364 of title XIII of the Act of August 1. L. 1999 . It also protects consumers against abusive practices such as charging unnecessarily high closing costs. jurisdiction. 88 Stat. 93-383. 98--181. the servicer of any loan secured by the property covered by the contract. 90--448). Real Estate Settlement Procedures Act .purpose is to ensure that consumers are provided with timely.http://www. Any regulations issued under this paragraph shall be consistent with and substantially identical to the regulations issued under paragraph (1) of this subsection. 1983. 1974. (This information was taken from the U. 2263). foreign policy and national security goals. 97 Stat.S.html. and involve close cooperation with allied governments. 1983 (Pub.ustreas.S. OFAC acts under Presidential wartime and national emergency powers. The following section is an excerpt of text of the Real Estate Settlement Procedures Act.gov/ofac/index. Many of the sanctions are based on United Nations and other international mandates.The Office of Foreign Assets Control of the U. detailed.gov/regulations/laws/rules/10000-3.S. and (if known to the Director) the owner of the loan. No. OFAC . REAL ESTATE SETTLEMENT PROCEDURES ACT OF 1974{*} An Act to further the national housing goal of encouraging homeownership by regulating certain lending practices and closing and settlement procedures in federally related mortgage transactions to the end that unnecessary costs and difficulties of purchasing housing are minimized. section 527 of title V of the Act of September 23. not less than 45 days before the expiration of any contract for flood insurance under this title. 1968 (Pub. amended by section 451(d)(1) of the Act of November 30. effective November 30. 220 . effective September 23.) 30. 1994] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 23. issue notice of such expiration by first class mail to the owner of the property covered by the contract.--The Director (or the designee of the Director) shall.) 29. as added by section 816(a) of title VIII of the Act of August 22. 108 Stat. Department of the Treasury administers and enforces economic and trade sanctions against targeted foreign countries. [Codified to 42 U.S Treasury Web site on December 31.C. terrorism sponsoring organizations and international narcotics traffickers based on U. L.S. (c) NOTIFICATION OF EXPIRATION OF INSURANCE. 1229). 1994 (Pub. No.220 described in subsection (a)(1) that is made by the Federal agency lender.fdic. and for other purposes. L. 1975] FINDINGS AND PURPOSE SEC.} SHORT TITLE SECTION 1.221 {* Delegation of Authority: Effective March 22.S. [Codified to 12 U. L. 3. (b) It is the purpose of this Act to effect certain changes in the settlement process for residential real estate that will result-(1) in more effective advance disclosure to home buyers and sellers of settlement costs. 93-533. No.8856}} 221 . (2) in the elimination of kickbacks or referral fees that tend to increase unnecessarily the costs of certain settlement services. This Act may be cited as the "Real Estate Settlement Procedures Act of 1974". 2. 1974 (Pub. [Codified to 12 U. 1976. 1974 (Pub. 93-533. The Congress also finds that it has been over two years since the Secretary of Housing and Urban Development and the Administrator of Veterans' Affairs submitted their joint report to the Congress on "Mortgage Settlement Costs" and that the time has come for the recommendations for Federal legislative action made in that report to be implemented. For purposes of this Act-(1) the term "federally related mortgage loan" includes any loan (other than temporary financing such as a construction loan) which-. 88 Stat. (3) in a reduction in the amounts home buyers are required to place in escrow accounts established to insure the payment of real estate taxes and insurance. Reg.C. March 29. the Assistant Secretary for Consumer Affairs and Regulatory Functions is authorized to exercise the power and authority of the Secretary of Housing and Urban Development with respect to the administration of the Real Estate Settlement Procedures Act of 1974. L. 12917. and (4) in significant reform and modernization of local recordkeeping of land title information. No. effective June 20. effective June 20. 1976). 88 Stat. 1724). 2601 note] [Source: Section 1 of the Act of December 22. (41 Fed. (a) The Congress finds that significant reforms in the real estate settlement process are needed to insure that consumers throughout the Nation are provided with greater and more timely information on the nature and costs of the settlement process and are protected from unnecessarily high settlement charges caused by certain abusive practices that have developed in some areas of the country. 1724). 1975] DEFINITIONS SEC.{{4-30-97 p.C.S. 2601] [Source: Section 2 of the Act of December 22. advance. the Federal Home Loan Mortgage Corporation. and also refers to any duly authorized agent of a title company.S. pest and fungus inspections. 1602(f)). partnerships. or assisted in any way.C. franchisor. by the Secretary or any other officer or agency of the Federal Government or under or in connection with a housing or urban development program administered by the Secretary or a housing or related program administered by any other such officer or agency. including any such secured loan. the proceeds of which are used to prepay or pay off an existing loan secured by the same property. the following: title searches. directly or through its agents. title insurance. and (8) the term "associate" means one who has one or more of the following relationships with a person in a position to refer settlement business: (A) a spouse. or (iv) is made in whole or in part by any "creditor".222 (A) is secured by a first or subordinate lien on residential real property (including individual units of condominiums and cooperatives) designed principally for the occupancy of from one to four families. (5) the term "person" includes individuals. and (B) either of such persons directly or indirectly refers such business to that provider or affirmatively influences the selection of that provider. the preparation of documents. (C) an employer. and the underwriting and funding of loans). loan processing.000. (3) the term "settlement services" includes any service provided in connection with a real estate settlement including. or other consideration. or (iii) is intended to be sold by the originating lender to the Federal National Mortgage Association. or an associate of such person. is controlled by. the Government National Mortgage Association. but not limited to. as defined in section 103(f) of the Consumer Credit Protection Act (15 U. service. officer. the taking of loan applications. or 222 . and trusts. partner. title examinations. guaranteed. has either an affiliate relationship with or a direct or beneficial ownership interest of more than 1 percent in a provider of settlement services. (4) the term "title company" means any institution which is qualified to issue title insurance. the term "creditor" does not include any agency or instrumentality of any State. services rendered by an attorney. director. (B) a corporation or business entity that controls. funds. but not limited to. or child of such person. (6) the term "Secretary" means the Secretary of Housing and Urban Development.000 per year. and (B)(i) is made in whole or in part by any lender the deposits or accounts of which are insured by any agency of the Federal Government. loan. and closing or settlement. or is under common control with such person. except that for the purpose of this Act. property surveys. and the handling of the processing. services rendered by a real estate agent or broker the origination of a federally related mortgage loan (including. who makes or invests in residential real estate loans aggregating more than $1. supplemented. the provision of title certificates. the rendering of credit reports or appraisals. or insured. (7) the term "affiliated business arrangement" means an arrangement in which (A) a person who is in a position to refer business incident to or a part of a real estate settlement service involving a federally related mortgage loan. parent. (2) the term "thing of value" includes any payment. or (ii) is made in whole or in part. or a financial institution from which it is to be purchased by the Federal Home Loan Mortgage Corporation. associations. corporations. or is made in whole or in part by any lender which is regulated by any agency of the Federal Government. No. 3401 note] [Source: Section 1100 of title XI of the Act of November 10. 1975.223 franchisee of such person. 1230). arrangement. a customer must be informed of the request. effective January 1.S. 110 Stat. effective June 20. 1100. No. 89 Stat. card issuer as defined in section 103 of the Consumers Credit Protection Act (15 U. 1992. or understanding.8857}} [Source: Section 3 of the Act of December 22. In some instances. 98-181. 1602(n)). This title may be cited as the "Right to Financial Privacy Act of 1978". 1974 (Pub.fdic. savings bank. 3009--400).S. No. 95--630. usually via a certification from the requesting agency. effective January 2. with such person. savings association.) 31. 102--550. the District of Columbia. any record held by a financial institution pertaining to a customer's relationship with the financial institution. L. the term-(1) "financial institution" means any office of a bank. 1992 (Pub. as amended by section 2 of the Act of January 2. TITLE XI--RIGHT TO FINANCIAL PRIVACY SEC. [Codified to 12 U. 1976 (Pub. 1101. L. 94-205.html. effective September 30. 93-533. 1724). notice or certification to the customer is not required. For the purpose of this title. trust company. 1999 . 1984. (2) "financial record" means an original of. L.http://www. section 2103(c)(1) of title II of the Act of September 30. For the most part. 92 Stat. 88 Stat. a copy of. No. Right to Financial Privacy Act . section 461(a) of title IV of the Act of November 30. section 908(a) and (b) of title IX of the Act of October 28. or information known to have been derived from. No. L. or consumer finance institution. industrial loan company.purpose is to outline and regulate the circumstances under which a financial institution is permitted to provide customer information to government institutions. 1978 (Pub L. 104--208.C.C. 1976. The following section is an excerpt of text of the Right to Financial Privacy Act. or the Virgin Islands. credit union.S. located in any State or territory of the United States. American Samoa. 97 Stat. 1979] DEFINITIONS SEC. 1983 (Pub. or homestead association (including cooperative banks). 2602] {{4-30-97 p. Guam. [Codified to 12 U. L.C. No. 1157). 223 .gov/regulations/laws/rules/10000-3. the purpose or substantial effect of which is to enable the person in a position to refer settlement business to benefit financially from the referrals of such business. such as a court or grand jury subpoena. building and loan. 106 Stat. 3873) effective October 28. 1996] (The information above was taken from the Federal Deposit Insurance Corporations Web site on December 23. effective March 10. 3697). or (D) anyone who has an agreement. Puerto Rico. 1996 (Pub. respectively). 104 Stat.S. (6) "holding company" means-(A) any bank holding company (as defined in section 2 of the Bank Holding Company Act of 1956). with respect to the Bank Secrecy Act and the Currency and Foreign Transactions Reporting Act (Public Law 91--508. L. in relation to an account mantained in the person's name. 1102. title I and II). and (8) "law enforcement inquiry" means a lawful investigation or official proceeding inquiring into a violation of. effective August 9. (G) the Secretary of the Treasury. 1990] CONFIDENTIALITY OF RECORDS--GOVERNMENT AUTHORITIES SEC. holding company. 101--647. {{10-31-94 p. 224 . 1978 (Pub. or for whom a financial institution is acting or has acted as a fiduciary. employee.02}} (4) "person" means an individual or a partnership of five or fewer individuals. 92 Stat. 1989 (Pub. (7) "supervisory agency" means with respect to any particular financial institution. (B) the Director.224 (3) "Government authority" means any agency or department of the United States. Office of Thrift Supervision. 3401] [Source: Section 1101 of title XI of the Act of November 10. (2) such financial records are disclosed in response to an administrative subpena or summons which meets the requirements of section 1105. section 2596(c) of title XXV of the Act of November 29. or any subsidiary of a financial institution or holding company. effective March 10. any of the following which has statutory authority to examine the financial condition. or order issued pursuant thereto. [Codified to 12 U. and (C) any savings and loan holding company (as defined in the Home Owners' Loan Act). (D) the Board of Governors of the Federal Reserve System. or records or transactions of that institution. L. business operations. or the information contained in the financial records of any customer from a financial institution unless the financial records are reasonably described and-(1) such customer has authorized such disclosure in accordance with section 1104. as amended by sections 744(b) of title VII and 941 of title IX of the Act of August 9.C. 1990 (Pub. Except as provided by section 1103(c) or (d). 1989. any criminal or civil statute or any regulation. or 1114. holding company. (B) any company described in section 4(f)(1) of the Bank Holding Company Act of 1956. effective November 29. or (H) any State banking or securities department or agency. No. 1113. (F) the Securities and Exchange Commission. (C) the National Credit Union Administration. 101--73. 95--630. L. or subsidiary-(A) the Federal Deposit Insurance Corporation. (E) the Comptroller of the Currency. rule. No. 103 Stat. 3697). no Government authority may have access to or obtain copies of.8598. or any officer. 438 and 496. 1979. 4908). No. or failure to comply with. (5) "customer" means any person or authorized representative of that person who utilized or is utilizing any service of a financial institution. or agent thereof. 92 Stat. 1978 (Pub.8598.03}} CONFIDENTIALITY OF RECORDS--FINANCIAL INSTITUTIONS SEC. or loan insurance agreement. loan guaranty. or officer. Such information may include only the name or other identifying information concerning any individual. employee. 95--630. 3697). or agent of a financial institution. law. law. [Codified to 12 U.S. shall not be liable to the customer under any law or regulation of the United States or any constitution. a Government guaranteed or insured loan. as an incident to processing an application for assistance to a customer in the form of a Government loan. 3402] [Source: Section 1102 of title XI of the Act of November 10. 1979] {{10-31-94 p. loan guaranty. 225 .C. (b) A financial institution shall not release the financial records of a customer until the Government authority seeking such records certifies in writing to the financial institution that it has complied with the applicable provisions of this title. L. or regulation of any State or political subdivision thereof to the contrary. or agent has information which may be relevant to a possible violation of any statute or regulation. or any officer. employee. may provide to any Government authority access to or copies of. or administering. or officer. for such disclosure or for any failure to notify the customer of such disclosure. effective March 10. (a) No financial institution. 1103. or loan insurance agreement. or regulation of any State or political subdivision thereof. or the information contained in. from providing copies of any financial record to any court or Government authority. (2) Nothing in this title shall preclude a financial institution. making a disclosure of information pursuant to this subsection. Such information may be disclosed notwithstanding any constitution. or otherwise collecting on a debt owing either to the financial institution itself or in its role as a fiduciary. the financial records of any customer except in accordance with the provisions of this title. or officer. or as an incident to processing a default on. proving a claim in bankruptcy.225 (3) such financial records are disclosed in response to a search warrant which meets the requirements of section 1106. from initiating contact with an appropriate Government authority for the purpose of providing any financial record necessary to permit such authority to carry out its responsibilities under a loan. (4) such financial records are disclosed in response to a judicial subpena which meets the requirements of section 1107. No. or agent thereof. or (5) such financial records are disclosed in response to a formal written request which meets the requirements of section 1108. (c) Nothing in this title shall preclude any financial institution. from notifying a Government authority that such institution. (d)(1) Nothing in this title shall preclude a financial institution. employees. Any financial institution. employee. or agent of a financial institution. corporation. or account involved in and the nature of any suspected illegal activity. as an incident to perfecting a security interest. a financial institution shall verify and record the name and address of the individual presenting a transaction. (c) The customer has the right. as amended by section 1353(a) of subtitle H of title I of the Act of October 27. 100-690. including the identity of the Government authority to which such disclosure is made. 93 Stat. Tax Identification Reporting (TIN Compliance) .S. L.C.8599}} authority pursuant to this section. 96-3. No. 5)] 32. such records may be disclosed. 1104. 3404] [Source: Section 1104 of title XI of the Act of November 10. 1988 (Pub. 95--630. (a) A customer may authorize disclosure under section 1102(1) if he furnishes to the financial institution and to the Government authority seeking to obtain such disclosure a signed and dated statement which-(1) authorizes such disclosure for a period not in excess of three months.purpose is to ensure that an adequate audit trail exists to reduce money laundering activities from illegal enterprises. 103. (2) states that the customer may revoke such authorization at any time before the financial records are disclosed. 1979. L.C. 1988] CUSTOMER AUTHORIZATIONS SEC. 95-630. 3403] [Source: Section 1103 of title XI of the Act of November 10. of any person or entity on whose behalf 226 . No. effective March 10. (3) identifies the financial records which are authorized to be disclosed. L. 3207--21). L. 1979 (Pub. 4357). 1986. 3698). and section 6186(a) of title VI of the Act of November 18. [Codified to 12 U. if any. and (5) states the customer's rights under this title. as well as record the identity. effective March 10. 3698).S. (4) specifies the purposes for which. L. 92 Stat. (b) No such authorization shall be required as a condition of doing business with any financial institution.28 Identification required. 92 Stat. effective November 18. unless the Government authority obtains a court order as provided in section 1109. The TIN reporting compliance is a part of the Bank Secrecy Act (see section 21 above). and the social security or taxpayer identification number. to obtain a copy of the record which the financial institution shall keep of all instances in which the customer's record is disclosed to a Government {{10-15-90 p. No. No. 1978 (Pub.226 [Codified to 12 U. 102 Stat. section 1104(d) repealed by the Act of March 7. The following section is an excerpt of text of the Tax Identification Reporting section of the Bank Secrecy Act.22. 99--570. 1986 (Pub. 1979. Sec. 100 Stat. effective October 27. 1978 (Pub. 103. No. and the Government authority to which. Before concluding any transaction with respect to which a report is required under Sec. account number. 9. http://www. and the mere notation of ``known customer'' or ``bank signature card on file'' on the report is prohibited. the final rule replaced the former regulation's terms ``fiduciary'' and ``managing agent'' with the term ``fiduciary capacity.occ. (The information above was taken from the Office of the Comptroller of the Currency Web site on January 12. the final rule revised the terms that specify the types of activities governed by part 9.) used in verifying the identity of the customer shall be recorded on the report. or other official document evidencing nationality or residence (e. the driver's license number. alien identification card. One of the fiduciary capacities set forth in Sec. effective January 29. This action will assist banks in determining the extent to which their investment advisory activities are subject to the OCC's fiduciary rules.com/Regs-aag/bsa1. etc. Transactions with Affiliates – FRB Sections 23 A&B . 1996 Revision of 12CFR Part 9 On December 30..html#10328 33. the specific identifying information (i. a Provincial driver's license with indication of home address). that is normally acceptable within the banking community as a means of identification when cashing checks for nondepositors (e. 1997 (61 FR 68543). 1996.'' found at Sec. the account number of the credit card.g.treas. a drivers license or credit card).'' The concept of investment adviser for a fee is new to part 9.gov/ftp/regs/part9fr.e. Section B outlines specific restrictions and prohibitions related to transactions with affliates. if the bank receives a fee for its investment advice. other than a bank signature card.purpose of Section A is to protect banks from abuses in financial transactions with companies with which the bank is affiliated. Trust – 12 CFR Part 9 .bankinfo. and the OCC's addition of this term to the list of fiduciary capacities raised questions from the banking industry about what activities entail providing investment advice for a fee.. the OCC issued a final rule revising 12CFR part 9.2(e) is ``investment adviser.2(e). In each instance.227 such transaction is to be effected. Under the revised part 9. then part 9 governs that activity. A bank signature card may be relied upon only if it was issued after documents establishing the identity of the individual were examined and notation of the specific information was made on the signature card. if a national bank acts in a fiduciary capacity while engaging in an activity.9. Among other changes. 34. 2000 ..g. Verification of identity in any other case shall be made by examination of a document. Section A applies to all federally insured banks. In particular. Verification of the identity of an individual who indicates that he or she is an alien or is not a resident of the United States must be made by passport.txt) 227 .http://www.The Office of the Comptroller of the Currency (OCC) is amending its rules governing national banks' fiduciary activities by issuing an interpretive ruling to clarify the types of investment advisory activities that come within the scope of these rules. . Inc. 1999. Internal Audit II. Cannon Financial Institute. University of North Carolina-Charlotte.228 BIBLIOGRAPHY 1. 228 . 4. B. which of the following conditions is most likely to be cause for concern? A. B. C. conducting currency transactions in a manner to avoid reporting requirements. D. A fee is charged for the internal audit of the plan.229 STUDY QUESTIONS FOR VOLUME 2: BANKING INDUSTRY 1. which of the following would be considered an appropriate hedging strategy to prevent a decrease in net interest income? A. OREO Commercial loans Deposit accounts Investment portfolio 229 . granting exemptions to qualified businesses based on their demonstrated normal levels of cash business. Enter into an interest swap to receive fixed and pay floating rate payments. balancing cash in with cash out for a specific account or group of accounts to avoid reporting requirements. If a corporation has a liability sensitive gap in a rising interest rate environment. B. During an audit of Common Trust Funds. D. C. The public accounting firm certifying your bank’s financial statements also performs an independent audit of the fund. The fund valuation is only being performed on a quarterly basis. Which of the following is most susceptible to credit risk? A. 2. 3. The Bank Secrecy Act uses the term “structure” or “structuring” to refer to A. Purchase an interest rate floor. C. An outside counselor is providing advice to the fund for a fee. providing two or more layers of review for compliance with reporting requirements. C. Do nothing. Enter into an interest rate swap to receive floating and pay fixed rate payments. B. D. D. III and IV only A. The underlying securities are physically transferred between the parties to the repo on the start and maturity dates of the transaction. The repo has a maturity date that exceeds 50% of the remaining maturity of the underlying security on the date the repo is entered into. The repo matures at the same time as the underlying security. B. B. C. I and III only I and IV only II and IV only II. checking accounts. and money market mutual funds. checking accounts. II. The money supply (M1) includes A. currency. that securities sold under a repurchase agreement (repo) be recorded as sales (or purchases)? I. currency only. for regulatory financial reporting purposes. IV. C. C.230 5. D. 230 . 7. currency and checking accounts only. currency. B. and non-checking savings deposits. how should the lease be treated? A. The market value of underlying securities is greater than 100% of the principal of the repo. In which of the following situations would the OCC require. D. As a sale of the lessor and a purchase by the lessee As a lease by the lessor and a purchase by the lessee As a sale by the lessor and a lease by the lessee As a lease by the lessor and a lease by the lessee 6. D. III. In a lease agreement that transfers the risks and rewards from the lessor to the lessee. 231 8. C. III and IV only. B. A. D. II and IV only I. A. III. I. IV. II. II. II and III only. III and IV only. B. II and III only I. II and IV only. The activity date used to determine dormancy is updated by internal debit memos. B. III. II. Federal Reserve Bank Securities and Exchange Commission Office of the Comptroller of the Currency National Credit Union Administration I. III and IV 231 . Mortgage servicing rights derive their value from which of the following? I. II. D. servicing fee income payment “float” prepayment charges late payment charges III and IV only I. C. Which of the following are members of the Federal Financial Institutions Examination Council (FFIEC)? I. Accounts are automatically coded dormant status after two years with no activity. which of the following procedures would you be most likely to consider a concern? A. 10. 9. IV. During a review of dormant savings accounts. C. I. Signature cards for dormant accounts are segregated and placed under dual control. D. Positive confirmations are sent just prior to accounts going dormant. 232 VOLUME III INSURANCE 232 . work out of a private office or their home. The following are examples of illegal sales practices: a. 3. 4. Agents are insurance company representatives with the authority to sell the company’s products. Sales is the process of agents addressing potential customers and writing applications for new policies. and distribution. compliance. reinsurance. A. Captive agents who work out of a field office are known as a company’s field force.233 CORE COMPETENCY NUMBER THREE: INSURANCE INDUSTRY UNIT 1: APPLICATIONS/PROCESSES This unit covers the common applications and processes associated with the operation and management of insurance companies. Sales. An insurance company is considered authorized or admitted if it holds a valid certificate of authority from the insurance department in the state in which it does business. 233 . underwriting. 2. 5. However. Marketing. Independent agents represent more than one company. and Distribution Systems 1. also known as exclusive agents. and administration. some agents. The function of an insurance broker is to choose the best coverage available to meet a client’s needs. represent one company exclusively. These applications and processes include marketing. Agents are also forbidden from guaranteeing policy dividends. investment operations. Most agents conduct business through authorized companies. Insurance brokers work for insureds rather than for a specific company. Agents must be licensed in the state in which they do business. sales. financial reporting. Captive agents. risk management. Marketing is the process of identifying customers and developing products and processes to meet their needs. actuarial. Misrepresentation occurs when agents make false or misleading statements in an attempt to encourage an individual to buy a policy. known as detached agents. An unauthorized or non-admitted insurance company does not qualify for a certificate of authority. premium audit. claims. Underwriting 1. Personal selling distribution systems market products by using sales representatives to make face-to-face presentations with prospective clients. direct mailings. and medications. b. Two common agency-building distribution systems include ordinary and multiple-line: 1. A distribution system is the network of individuals and organizations that perform the marketing activities required to convey the insurer’s products to its customers. Direct response distribution systems use telemarketing. and other advertisements to solicit potential customers. Underwriters evaluate insurance applications and determine the degree of risk they present to the insurer. treatments. Sales representatives working in personal selling distribution systems are paid by commission or salary or a combination of both. 2. Twisting occurs when an agent purposefully misguides an individual into canceling one policy and purchasing a new one. Underwriters may obtain information about an applicant’s finances or background by reviewing consumer credit reports. 234 . 3. The ordinary agency system (also known as the career agency system) uses agents usually working out of a company’s branch offices to sell policies. 6. A health insurance application. c. The multiple-line (or all-lines) agency system uses agents who sell the policies of a group of affiliated companies. underwriters review information about the proposed insured that is contained on the insurance application prepared by the insurance agent (sometimes also referred to as a field underwriter). There are two commonly used distribution systems in the insurance industry: a. should contain specific information about the proposed insured’s medical history. Clients purchase policies and file claims directly with the company rather than through a sales representative. Rebating occurs when an agent agrees to give an individual a share of the commission as an incentive to buy a policy. In attempting to assess acceptable risks. A major type of personal selling distribution system is the agency-building distribution system. for example. 2. including specific diagnoses. B. Underwriters may conduct physical inspections to ascertain hazards affecting property and casualty applications. The function of the underwriter is to determine acceptable risks and to calculate appropriate premiums.234 b. 4. substandard. Reinsurance occurs when an insurance company buys insurance from another company. and the excess beyond that limit is ceded to another reinsurer. 6. However. Insurance companies typically reinsure their policies either because an applicant wants a larger death benefit or presents a greater risk than the insurer can safely assume. or computer screening. which uses trained personnel to quickly approve applications that clearly meet acceptable criteria. Underwriters also use judgment to assess appropriate premium levels. 4. the reinsurance treaty does not specify the proportions of risk carried by each company. Any amount exceeding the retention limit is reinsured. The insurer breaks even when the combined loss and expense ratio is 100%. A facultative reinsurance treaty allows to reinsurer to make an underwriting decision for each risk sent by the ceding company. Auditors can judge the quality of the underwriting function by reviewing loss and expense ratios. The ceding company often sets a retention limit. A loss ratio is calculated by dividing losses by total premiums earned. Many insurance companies improve the efficiency of the underwriting process by using jet screening. Underwriters assign applicants to a risk class. There are two major types of reinsurance plans: proportional and non-proportional. The reinsurance contract is called the reinsurance treaty. This process is called retrocession. or for all business written by an insurer. An automatic reinsurance treaty allows the reinsurer to provide reinsurance automatically for all amounts in excess of the ceding company’s retention limit up to a specified amount. C. the reinsurance treaty specifies the proportions of risk that the ceding company and the reinsurer will bear. preferred. In a non-proportional reinsurance plan. An underwriting loss is experienced when the combined ratio exceeds 100%. 7. known as the automatic binding limit. or direct writing company. The company that accepts the risk of another reinsurer is the retrocessionaire. The company accepting the risk is the reinsurer or assuming company.235 5. nonsmoker. excluding investment income. An expense ratio is calculated by dividing an insurer’s total written operating expenses by total premiums. and uninsurable. Rates are often developed by assessing the loss history for a particular class. The reinsurer also sets a retention limit. by agency or agency. In a proportional reinsurance plan. which is the maximum amount of insurance that a company will carry at its own risk. 235 . each insurer has its own risk classes and acceptable levels of risk. which uses computer programs to screen applications. 3. Common risk classes include standard. The reason a company buys reinsurance is to cover part of all of the risk it has undertaken. by line of insurance. Loss ratios can be calculated by account. The company reinsuring its risks is the ceding company. 2. and an underwriting gain occurs when the combined ratio is less than 100%. Reinsurance 1. policy lapses. 2. also known as an excess-loss plan. Actuarial 1. There are three types of proportional reinsurance: a. Claims 1. Under yearly renewable term (YRT) plans. The reinsurer’s liability is limited to a maximum amount per catastrophe. The claims function is concerned with ensuring that claims are paid promptly and correctly to the claimant (e. There are two types of non-proportional reinsurance plans: a. expenses. Under a modified coinsurance (modco) plan. insurance rates. and group insurance typically uses non-proportional reinsurance plans.g. and other statistical projections. b. except that the ceding company holds the reserves for the entire policy. 5. the insured or its beneficiaries). also known as risk premium reinsurance (RPR) plans. Under a stop-loss reinsurance plan. 6. the reinsurer agrees to pay losses in excess of the plan deductible when more than a specified minimum number of claims result from a single accidental occurrence.and long-term trends in interest rates. Under a coinsurance plan. E. and policy loans. the reinsurer agrees to pay a percentage of all claims paid by the ceding company that exceed a specified amount in a certain period. Actuaries also conduct research on short. expected loss ratios. D. 236 . such as a hurricane or earthquake. injury rates. the ceding company pays the reinsurer part of the premium paid by the insured and the reinsurer in turn agrees to pay the ceding company part of the death benefit when a claim is filed. c.236 Individual insurance typically uses proportional reinsurance plans.. Actuaries apply mathematical and statistical principles to calculate and predict death rates. They are also responsible for calculating the value of the company’s reserve liabilities. the ceding company purchases yearly renewable term insurance from the reinsurer in the amount being reinsured. illness rates. Under a catastrophic reinsurance plan. the provisions are similar to a coinsurance plan. b. Was the policy in force when the loss occurred? d.237 2. Some property insurance policies may require the insured to have an appraisal of the property before a claim is paid. Claim specialists should be trained to recognize instances of insurance fraud or improper claims. Did a loss occur? b. 8. 6. Exclusions: Expenses that the policy does not cover. before approving a claim. How much is payable to the insured or beneficiaries? f. There may be time limits regarding when a claim can be filed. 9. the insurance company may file a bill of interpleader with a court. The purpose of a claim investigation is to gather additional information related to the claim. Insurers may also require additional evidence. when no clear beneficiary can be determined. 3. Who are the beneficiaries? 7. such as a death certificate or a physician’s statement. and the length of time the policy was in force. Arbitration is often used to settle claims when the insured or insurer cannot agree on the amount of loss. For life insurance policies. the insured may be required to file a signed proof of loss statement. The insured is generally responsible for notifying the insurer in writing when a loss occurs. 5. the nature of the loss. Risk factors that may signal a need for an investigation include the amount of the claim. and then the court decides how to settle the claim. the presence of conflicting information. Depending on the type of claim. 237 . Insurance companies decide on a case-by-case basis whether an investigation is necessary. These may range from cosmetic surgery to self-inflicted injuries. Questionable claims may be subject to a claim investigation. Was the insured covered by the policy? e. 4. Health insurance claims may be subject to the following provisions: a. Claim specialists (commonly referred to as claim examiners or claim analysts) consider information related to the approval or denial of a claim. The claims department considers the following questions when reviewing claims: a. Was the loss covered by the policy? c. The interpleader allows the company to pay the policy proceeds to the court. Most policies outline the proper procedures for filing a claim. This scenario would result in a customer incorrectly believing that they are covered for a specific occurrence. and private investors use financial information to evaluate a company’s performance relative to other companies in the industry. Stockholder reports c. independent agents will fail to inform the insurance company that a customer requests specific coverage. Comparison of one company’s financial results to another company e. Comparison of financial results in two or more financial periods d. Waiting Periods: A prescribed amount of time after the policy is issued before medical expenses are covered. Audited financial statements b. Co-payments: The percentage of expense that the insured must pay. d. Financial reports help the insurance company monitor its financial position and plan its operations. Industry analysts. plus any deductible amount. The insurance company agrees to pay the remaining amount for covered expenses. If such a loss occurs. c. Occasionally. Pre-existing Conditions: Injuries or medical conditions that are excluded from coverage because they occurred before the policy was issued. For example. many policies require the insured to pay 20 percent of covered expenses. F. The coordination of benefits clause designates a primary provider. f. Comparison of sales to sales goals 238 .238 b. Financial Reporting 1. brokerage houses. 10. Types of financial reports and analyses used in the insurance industry include: a. After the primary provider pays its share of the claim. Insurance regulators and the National Association of Insurance Commissioners (NAIC) also use financial information to analyze a company’s financial position. most companies will still reimburse the customer and charge the amount to the agency’s errors and omissions policy. Deductibles: An amount the insured must pay before any medical expenses are covered. 2. the insured may file a claim for the remaining amount with the insurers on the other policies. However. Coordination of Benefits Clause: Prevents the insured from receiving more than 100 percent of medical expenses incurred in cases where the insured has more than one medical policy. the insurance company will deny the claim. e. policy loans. undue influence. insurance companies must adhere to capital and surplus requirements. binding contract: a.239 f. insurers might assume an amount of risk beyond their capacity to pay claims. Each state has its own insurance laws governing financial stability. In order to reduce the risk of insolvency. d. State insurance laws are known collectively as insurance law. Comparison of actual expenses to budgeted expenses g. and regulative agents. 3. b. or duress are used in securing the agreement of another party. Budgets are a plan for allocating financial resources during a specific period. 4. Agreement: A valid contract involves one party making an offer and the other party accepting that offer. The legal department assists in resolving contract disputes related to insurance policies. There are four elements that constitute a legal. 2. Insurance industry revenue consists primarily of premium receipts and investment income. There are several types of budgets: a. beneficiaries. insurance products. The contract is not considered valid if fraud. Individual state governments have the primary responsibility for regulating the insurance industry. c. . stockholders. Revenue budgets project income for the coming year. employees. Compliance 1. Capitol expenditure budgets are used to allocate funds for major purchases. sales expenses. These limits are set by states to define the insurer’s capacity or limit on the amount of business that the company may own. The courts regard insurance policies as legal contracts. Expense budgets project the company’s possible expenses from items such as claims. policy dividends. Insurance companies typically have legal responsibilities to insureds. 239 . Comparison of claims paid to projected claim expenses 3. and general business conduct. Without these limits. The purpose of budgeting is to assist management in planning the company’s operations. Cash receipts and disbursements budgets are used to monitor cash flow. G. The legal department is assigned the responsibility of ensuring that the company’s operations comply with applicable laws and insurance regulations. and administrative expenses. For insurance contracts. Legal Purpose: A valid contract must have a legal purpose. may take the form of money. Assisting the claims department in resolving settlement disputes c. Investment Operations 1. Applying real property laws that govern the company’s investments in real estate f. Reviewing policy drafts to ensure they comply with applicable laws and regulations b. 4. Some life. and the insurer’s consideration is the promise to pay after a loss occurs. This exchange of value. and people under the influence of alcohol or drugs. c. Competent Parties: A valid contract must involve legally competent parties. For example. Applying corporate laws to proposed mergers and takeovers i. Consideration: A valid contract involves each party giving something of value. action. An adult parent or guardian is usually required to sign a minor’s insurance application in order to avoid any legal confusion.240 b. Initiating or responding to litigation H. the insured’s consideration is the payment of premiums and a promise to fulfill the conditions of the contract. or promise. Types of parties typically considered not legally competent to enter into contracts include minors. health. Applying securities laws that govern the company’s sale and purchase of stocks and bonds e. Most commercial insurance companies are owned by stockholders and are known as stock companies. or property/casualty companies are set up as mutual companies that are owned by policyholders. Applying employment laws that govern employee rights and collective bargaining agreements g. Proper management of these investments is of prime 240 . insurers cannot issue polices to cover intentional or criminal actions. These insurance companies invest billions of dollars of corporate assets each year. and every insured must have a valid insurable interest. Interpreting tax laws that apply to employee benefits and settlement payments h. Drafting agreements that outline the relationship and responsibilities of the company and its agents d. The legal department is responsible for these other duties: a. people with mental impairments. d. or consideration. 3. of the many people who buy earthquake insurance. including its investment portfolio. Insurance is a method of transferring. the board of directors of an insurance company typically appoints members to serve on an investment committee or finance committee. or adversely affected in some other way. Specific types of approved and forbidden investments d. some companies use a portfolio manager to focus only on the assets in the investment portfolio. Companies and individuals may also choose to retain a portion of the risk through the use of deductibles or co-payments. The concept of insurance is based on the fact that there is risk that the thing being insured will be lost. insurers can insure a large number of people against a given peril. Risk can be avoided by removing the exposure through change (such as changing a behavior or removing a hazard). including desired rates of return b. Dollar levels that investment personnel can approve at various levels of authority I. 241 . Transferring risk through insurance is not the only method of reducing risk. Consequently. damaged. For example. only a small percentage will suffer earthquake damage to their property. the financial responsibility for the risk to another party. Risk Management 1. Risk pooling is based on fact that the probability of any one type of loss occurring for a given individual is small. Insurance companies assist individuals in managing personal risk through risk pooling. earthquake insurance will cost more in high-risk areas. Therefore. injured. The purpose of the investment committee is to develop general investment policies for the company. 2. Acceptable risk levels for investments to help ensure the safety of assets c. 3. bonds. Specific functions of the investment committee may include setting: a.241 importance to policyholders and stockholders. The investment portfolio is the aggregate name for the company’s investments in stocks. for a fee. 2. The performance of these investments can also affect the premium prices that a company charges for its insurance products. Company executives or influential stockholders may also serve on the investment committee as outside directors. Many insurance companies employ an asset manager to manage all of the company’s assets. Investment objectives. and real estate. 4. Risk can also be reduced (such as by implementing additional controls). based on the knowledge that only a small percentage of those insured will ever file a claim for that particular peril. The need for a company to produce high investment returns is mitigated by the need to minimize the risk of financial loss. Instead of hiring an asset manager to manage all assets. However. mortgages. destroyed. Factors considered include 242 . Premium Audit 1. Group insurance billing plans can be self-administered or insurer-administered. Insurance companies now often use a preauthorized payment system or a lock-box system to collect premiums. When a policyholder’s coverage is specifically expanded or limited. Traditionally. Under a preauthorized payment system. The bank collects the checks for the insurance company and deposits them directly into the company’s account. The customer service department is often charged with evaluating requests for supplementary benefits riders. 3. as well as calculating and mailing monthly premium statements to the policyholder. the policyholder performs most of the administrative functions. auditors/accountants should determine that the premium billings are timely and accurate. a rider is issued to describe the change. policyholders authorize the insurance company to withdraw premiums from their savings or checking accounts. Administration 1. Premium auditing focuses on the billing and collection processes. The insurance company performs these functions. and that collections are properly recorded in accounting statements and on policyholders’ records. Supplementary Benefit Riders. The customer service department is responsible for the day-to-day administration of insurance policies. Underwriters and actuaries help insurance companies assess risks. The customer service department is often charged with administering the conversion and adjusting premiums if necessary. Conversion privilege. Under a selfadministered billing plan. Insurance companies collect premiums in a variety of ways. payments are sent to a post office box accessible by the bank. The functions of the customer service department may include providing general assistance to customers. such as keeping the group’s records and processing required paperwork. 2. These functions are discussed elsewhere in this CFSA Study Guide. Specific policy changes that policyholders can request include: a. J. 2. K. b. Specifically. Members under group policies often have the right to convert to individual coverage.242 4. calculating and processing policy loans and dividends. The rider becomes part of the insurance contract. and sending premium notices and collecting payments. Under a lock-box system. under an insurer-administered billing plan. The premium withdraw under a preauthorized payment system is often done via an electronic funds transfer (EFT) system. making changes requested by policyholders. policyholders receive premium notices and pay one premium at a time by mail. 3. 4.243 type and amount of coverage currently in force. For example. usually no more than five years after the policy lapsed. type and amount of extra coverage requested. including any interested charges assessed by the insurance company. The customer service department must ensure that several factors are met when considering the reinstatement of lapsed policies: a. c. the customer service department must determine the policy’s final cash value by adding any accumulated dividends and subtracting any loan amounts payable. The policyholder must repay all unpaid premiums. The policyholder must show evidence of insurability. d. Responsibility for reissuing policies often rests with the customer service department. b. Insured changes usually occur when a key person insured by an organization terminates employment. and length of time since the policy was issued. insurance companies often reissue these policies under the name of the new key person. The policyholder must submit a written request within a specified time period. a policy would be reissued if the original policy contained an error or omission. risk factors associated with the policyholder. 243 . Reissues. c. Any loans against the policy must be repaid or restored. Policies may also be reissued in order to reduce the death benefit amount or to change insureds. Policies are occasionally reissued for various reasons. When a policyholder initiates the replacement of an old life insurance policy with a new life insurance policy. The Act allowed states to retain the right to regulate the insurance industry. B. Verify that policy forms meet all requirements and contain all provisions and disclosures 244 . 3. Hold hearings and suspend or revoke licenses or certificates of authority e. or director. A. Issue licenses to insurance agents d. 2. State Insurance Commissions 1. The Act allowed the federal government to assume regulation of the insurance industry if Congress feels that state regulation is inadequate or does not serve the public interest. Because the states regulate the insurance industry. The major regulations and regulatory entities affecting the insurance industry are described below. Make the state’s insurance rules and regulations b.244 UNIT 2: LAWS AND REGULATIONS The insurance industry is regulated by state governments. each state must have an insurance commission. 4. The McCarran-Ferguson Act (Public Law 15) 1. the federal government. and nongovernmental entities. Review insurance companies’ financial statements f. Each state’s insurance commission holds legal authority over insurance company operations. Each state’s insurance commission is directed by a state insurance commissioner. The responsibilities of state insurance commissions include: a. superintendent. 2. 3. The McCarran-Ferguson Act was passed in 1945. Authorize companies to operate in the state thorough the issuance of licenses and certificates of authority c. The NAIC Financial Regulation Standards and Accreditation Program (adopted June 1990) set up a system of peer review among state insurance commissions. the NAIC has no direct regulatory authority. However. The NAIC is a non-governmental organization comprised of the various state insurance commissioners. A zone examiner may be assigned from any zone in which a company receives as much as $1 million premiums or more than 20 percent of its total premiums. The NAIC divided the United States into four zones (western. Examiners from other states in the zone may also participate in the examination. The final report of the examination is a matter of public record. southeastern). northeastern. The following guidelines apply to insurance company examinations: a. Receive and follow-up on consumer complaints C. b. 3. Insurance companies are usually examined once every three to five years. 5. The National Association of Insurance Commissioners (NAIC) 1. The examiner-in-charge must be from the company’s home state. f. midwestern. 4. The NAIC created a zone system to streamline the financial examination of companies operating in more than one state. superintendents. c. The home-state commissioner is responsible for resolving any disagreements that arise between the examiners and the company regarding the content of the final report. Each zone has a pool of examiners supplied by the each state’s insurance commission within the zone. g. or directors. 2. Ensure insurance company compliance with reserve requirements and investment guidelines h. A major function of the NAIC is to encourage uniformity among state insurance departments through the development of model bills and regulations. The NAIC Financial Regulation Standards (adopted September 1989) recommend minimum levels of resources and authority necessary for effective solvency regulation. e. A written report of the examination must be issued. 245 .245 g. d. accident. which includes severance benefits and housing benefits. ERISA requires that welfare benefit plans have a written plan document that describes the benefits of the plan. Apprenticeship or training programs h. Welfare Benefit Plans are subject to ERISA if they offer any of the following benefits: a. A fiduciary can be held personally liable for any losses that result from a failure to follow guidelines set in ERISA. These products. The Securities and Exchange Commission (SEC) 1. Day-care benefits e. Vacation benefits d. The written plan must also name the fiduciary responsible for managing the benefit plan. or unemployment benefits c. ERISA defines a welfare benefit plan as any plan an employer establishes to provide certain benefits to plan participants and their beneficiaries. Investment-based life insurance products or variable insurance products include annuities. Employment Retirement Income Security Act (ERISA) 1. be licensed as a broker/dealer with the National Association of Securities Dealers (NASD). disability. Prepaid legal services g. and variable universal life insurance. described in the Labor Management Relations Act 246 . an be licensed as a state insurance agent. or hospital care benefits b. 2. 2. how the plan will be funded. which are also known as non-guaranteed products. Agents selling investment-based insurance products must be certified by the SEC.246 D. 3. Medical. Insurers that sell investment-based insurance products must comply with federal laws that govern securities. and how the plan will be amended if necessary. are considered speculative because the cash value or benefit level can change relative to the performance of the insurer’s investments. surgical. Sickness. death. E. ERISA is a federal law that governs welfare benefit plans and employer-sponsored retirement plans. Certain benefits. The SEC has regulatory authority over investment products. variable life insurance. Scholarship funds f. Group Health Insurance Definition and Group Health Insurance Standard Provisions Model Act (Group Health Insurance Model Act). Each plan participant and the Department of Labor must also be informed of any significant changes to the plan. F.247 ERISA requires that a summary plan description be provided to each plan participant and to the Department of Labor. Model Health Maintenance Organization (HMO) Act. which lists requirements for qualifying as an HMO e. Participants are vested when they can receive partial of full benefits even if they terminate employment prior to retirement. Uniform Individual Accident and Sickness Policy Provision Law (Individual Health Insurance Model Law). which lists unethical practices for claims personnel 247 . b. 2. c. which is designed to regulate individual health insurance policy provisions b. states may adopt the model laws as written or they may modify them to meet their specific situation. The National Association of Insurance Commissioners (NAIC) develops model laws to encourage uniformity among states. Model Claims Settlement Act. which provides guidelines for regulating group life insurance programs d. As the NAIC has no regulatory authority. ERISA also requires that plan administrator file the plan’s annual report with the Internal Revenue Service. Group Life Insurance Model Act. A participant’s right to receive benefits must vest within a specified period after the participant becomes eligible to join the plan. Major requirements of ERISA include: a. 3. State Model Laws 1. 3. which defines eligibility for group health insurance and outlines specific policy provisions c. Qualified retirement plans are prohibited from discriminating in favor of highly paid employees. Examples of NAIC model laws include: a. Fiduciaries must ensure the safety of the plan’s assets. ERISA contains standards that all retirement plans must meet. which requires policies covering dependent children to also extend coverage to newborn children of the insured. Group Health Insurance Mandatory Conversion Privilege Model Act. which establishes uniform overinsurance provisions to allow for expedited payment of claims and conflict resolution when the insured has duplicate coverage by more than one insurer 248 . Group Coordination of Benefits Regulations and Guidelines.248 f. Model Newborn Children Bill. h. which allows insureds under group health policies to convert to an individual health insurance policy if either their employment or the group contract terminates g. each premium payment is lower than for limited payment policies.249 UNIT 3: PRODUCTS This unit is divided into two sections. PENSION. These individuals must purchase individual insurance policies. and annuity and (2) property and casualty. 249 . The actual cash value payable to the policyholder in this circumstance would be less any surrender charges or policy loan repayments outstanding. every five years) during the life of the policy. even if the policyholder is still living. the contract between the insurer and the insured describes applicable coverages. and endowments. INDIVIDUAL INSURANCE Some people do not qualify for group insurance policies. The cash value usually does not equal the face amount of the policy until the policyholder reaches the age at the end of the mortality table used to calculate the premiums for the policy. usually age 99 or 100. 2. This allows young policyholders to purchase a higher level of coverage than they may otherwise be able to afford. or single premium policies. term life. Premiums are payable under continuous premium policies until the death of the insured. Whole life insurance offers lifetime coverage at a level premium rate that does not increase as the insured ages. the insurance company usually pays the policyholder the full face amount of the policy. Premiums for limited payment policies are payable for a stated period (for example. In an individual insurance policy. limited payment policies. Because premiums are payable for a longer period. At that time. premium payments increase at specified intervals (for example. Typically. Single premium policies require only one premium payment. 3. pension. This section looks at four types of individual insurance: whole life. The sections cover the two basic categories of insurance products: (1) life. Whole life policies accrue a cash value that the insurer must surrender to the policyholder if the policy does not remain in force until the policyholder’s death. LIFE. and benefits that are specific to the individual policy. Whole life policies are classified as continuous premium policies (or straight life policies). whichever comes first. universal life. exclusions. AND ANNUITY PRODUCTS I. 20 years from the policy’s inception or until the insured reaches a certain age) or until the death of the insured. Modified premium whole life policies have premium payments that change during the life of the policy. A. Whole Life Insurance 1. a $50. 5. 250 . However. B. to $30.000 the third year. For example. Increasing term life insurance policies provide an increasing amount of death benefit throughout the life of the policy. Joint whole life policies (or first-to-die policies) insure two lives under one policy. to $20. such as 55. Term Life Insurance 1. an increase in the premium for the permanent coverage cannot be based on level of the insured’s health. Renewable term insurance policies contain a renewal provision that allows the policyholder to renew the term policy at the end of the term. Term life policies provide a death benefit when the insured dies during a specified period. the policy expires. but may be up to 40 years or more. even if the insured has serious health problems. the renewal premium is based on the insured’s age at the time of conversion. Term policies often contain provisions that allow the policyholder to keep life insurance coverage after the policy expires. Death benefits are paid to the surviving insured. Premiums for decreasing term policies usually remain level throughout the term of coverage.000 in benefits payable the second year. At the end of the fifth year. original age conversions base the premium for permanent coverage on the insured’s age at the time the original term policy was purchased. the premium rate increases when the policy is renewed. The surviving insured usually has the option of purchasing an individual whole life policy of the same face amount without providing evidence of insurability. The policy’s death benefit begins at a set value and gradually decreases to a level stated in the policy. Last survivor life insurance policies (or second-to-die policies) pay benefits only after both insureds covered by the policy have died. 3. Decreasing term life insurance policies provide decreasing policy benefits over the term of coverage. Some insurers reduce their risk by not permitting conversions after a specific age. Married couples typically use this type of policy to pay estate taxes after they die. Convertible term life insurance policies contain a conversion privilege that allows the policyholder to convert the term policy to permanent coverage without providing evidence of insurability.000 the fourth year. Level term life insurance policies provide the same level of death benefit throughout the term of the policy. 5. On the other hand. and to $10. The term of this type of policy is usually not less than one year. Term life provides only temporary protection because coverage ends at the end of the term of coverage stated in the policy.000 in the final year.250 4. 2. Therefore.000 five-year policy might decrease to $40. The premium for a level term policy usually stays the same throughout term of coverage. When term policies are converted under an attained age conversion. Premiums for increasing term life policies usually increase during the term of coverage. 4. . as well as minimum initial payment amounts.g. However. Whole life policies do not accrue a reserve and cash value equal to the face amount until the insured reaches the age at the end of the mortality table used to calculate the policy’s premium (usually age 99 or 100). as long as the cash value is large enough to pay the periodic charges assessed by the insurer. an endowment policy builds cash value more rapidly than a comparable whole life policy. Expenses associated with administering the policy 2. 251 . Interest rate paid on the cash value c. Mortality charges based on the insurer’s risk classification b. which is typically for a much shorter period than for a whole life policy..251 C. Endowment policies are similar to permanent life insurance policies in that premiums are usually level throughout the term of the policy and the policies build cash values. This is because the reserve and cash value of an endowment policy usually equals the policy’s face amount on the policy’s maturity date. even if no premiums are paid. If the insured survives to the maturity date of the policy b. If the insured dies before the maturity date of the policy is reached Policy maturity dates may be set either when the insured reaches a certain age (e. the policy will remain in force. However. Purchasers of universal life policies specify the policy’s face amount and whether the death benefit will be level or vary as the policy’s cash value changes. Universal life insurance policies accumulate cash values that are tax deferred. age 65) or after a stated period of time has elapsed (e. 3. Within limits. Endowment insurance provides a specified benefit amount in either of the following cases: a. and separate pricing for the three major pricing categories: a. Under level death benefit policies the death benefit payable equals the policy’s face amount. Under variable level death benefit policies the death benefit is equal to the policy’s face amount plus any accumulated cash value.g. flexible face amounts. Insurance companies set maximum payment amounts to maintain the policy’s status as a contract. universal life policyholders can choose how much to pay for initial and subsequent premiums. 2. 4. Universal life insurance is a form of permanent life insurance that has flexible premiums. D. Endowment Insurance 1. Universal Life Insurance 1. 20 years) from the date the policy is issued. and administrative service only. The group insured also has the right to change the named beneficiary. The amount of individual coverage the individual can purchase may be limited to the amount of insurance held under the group policy.252 II. each group insured can name a beneficiary who will receive the benefits payable when the insured dies. managed care. In a noncontributory plan. accident and health. group insureds pay a premium in order to receive coverage under the plan. typically through a payroll deduction. 4. group insureds do not pay any premium for the coverage. 252 . Under all types of group life insurance policies. known as a master group insurance contract. X amount for all group insureds or X amount for all group insureds in a specific job classification). Also covered are the different ways to administer group insurance including health maintenance organizations. All members of a group insurance plan (group insureds) are covered under a single contract. The National Association of Insurance Commissioners (NAIC) Model Act requires that group life policies have a conversion privilege that allows a group insured whose group coverage terminates to convert to an individual life insurance policy without providing evidence of insurability. GROUP INSURANCE Insurance that employers provide to employees through an employee benefit plan is known as group insurance. 2. or it may be set in the policy (e. A group policy cannot describe coverage amounts for specific individuals. Group policies usually contain a benefit schedule that is used to determine the amount of life insurance for group insureds and their dependents covered under the plan. Insureds are allowed a 31-day conversion period to purchase the individual insurance without providing evidence of insurability. Insurance companies must charge the standard premium rate that any individual of the insured’s sex and age would normally pay for the type of policy being issued.000 or the amount of coverage previously held under the terminated plan minus the amount of group coverage for which the insured becomes eligible for within 31 days of the policy termination. In a contributory plan. A.g. preferred provider organizations. The NAIC Model Act requires that group insureds covered under a policy for at least five years be given the right to convert to individual coverage if the group policy terminates. The employer or entity purchasing the group insurance is known as the group policyholder.. utilization management. The maximum amount of individual insurance the insured can purchase is the lesser of either $10. The coverage amounts may be determined by a formula. such as a multiple of the employee’s salary. 5. and dental. group life policies usually include provisions for eligibility requirements and termination clauses. 3. The provisions of group life insurance policies are similar to those found in individual life insurance policies. Life Insurance 1. disability. For example. except creditor group life insurance policies. accidental death and dismemberment. This section covers the many types of group insurance including life insurance. 12 months). 7. Accident and Health 1. 5. purchasing individual insurance in addition to the new group policy coverage may result in the individual being overinsured. B. A group heath insurance policy is a contract between an insurance company and the employer or other group purchasing the policy.253 6. Optional dependent coverage is usually available through group policies for an additional fee. YRT policies do not build cash values. for 3 consecutive months) or if the individual has been covered under the group plan for a specified period (e. An exception to the conversion provision applies to individuals who are changing jobs and are being covered under another group policy.g. 8. The COB provision defines the group plan that will serve as a primary provider and the one that will be the secondary provider. 4. 3. Most group health policies contain a conversion provision that allows an individual leaving the group to purchase individual insurance without providing evidence of insurability. The insurer bears the cost of these examinations. Also. These policies do not require insureds to provide evidence of insurability when the policy is renewed each year. The primary provider is usually the one that covers the individual as an employee rather than as a dependent. Most group insurance policies are yearly renewable term (YRT) insurance plans.. the NAIC Model Act requires that the insurer pay the insured’s beneficiaries the largest amount the insurer would have issued as an individual policy to the group insured. After the primary provider pays all claims payable. Most group health policies contain a coordination of benefits (COB) provision to prevent individuals covered under more than one plan from receiving benefits greater than the expense incurred. Most policies also waive the pre-existing condition provision if the group switches carriers and the member was covered under the previous group policy. If the insured dies during the 31-day conversion period before being issued an individual policy. Some policies include exceptions to the preexisting condition provision which allow for coverage if the individual was not treated for the condition for a specified period (e. Employees or other individuals receive specific benefits covered in the policy. The insurer may also require the claimant to undergo periodic examinations to verify that the disability still exists. 253 . If an incorrect premium amount is paid because a group insured misstated his or her age.. the individual can submit any unpaid bills to the secondary provider. but they are not issued individual policies. the insurer will retroactively adjust the premium amount to reflect the insureds correct age. 2.g. In these cases. Group policies typically include a pre-existing condition provision that excludes coverage for conditions that the individual received treatment for during specified period (often three months) prior to the effective date of coverage. Most group disability income policies contain a physical examination provision that requires a doctor to examine a claimant before a claim is paid. 2. Disability income insurance is designed to provide income replacement for individuals who become unable to work because of an illness or accidental injury. and the number of males and females in the group. or experience. Some accidental death and dismemberment policies only cover accidents that occur while an employee is traveling on the job. Disability income policies usually provide an incentive for the insured to return to work by providing insureds less income than they received before they became disabled. or hearing loss. insureds may be considered disabled only if they cannot work in any occupation that they are reasonably fitted for by education. The waiting period is a specified time that must pass after a person becomes disabled before the insurance company begins making benefit payments. D. Short-term group disability income coverage provides benefits for less than one year. speech loss. 254 . Long-term group disability coverage allows insureds to receive benefits for more than one year. 4. 3. 2. However. Presumptive disability provisions allow the insured to be considered totally disabled if certain conditions arise. Accidental death and dismemberment policies pay stated benefit amounts if the insured dies as the result of an accident or if the insured loses limbs or eyesight. Many disability income policies include a waiting period. The cost of a group health insurance plan depends on the type of business in which the members work. C. Presumptive disability conditions typically include permanent blindness.254 6. Accidental Death and Dismemberment 1. The purpose of waiting periods is to reduce the need to pay for disabilities that last only for a short period. Accidental death and dismemberment policies are usually low in cost. Disability Income 1. training. The actual amount payable is typically based on a percentage of the insureds pre-disability earnings or flat rate determined when the policy is purchased. Disability income payments made through group policies usually cease when the insured returns to work in any gainful occupation. In order to receive benefits. Most policies initially define total disability as the inability of the insured to perform the duties of his or her regular occupation. 3. Insureds disabled in these ways receive full benefits even if they resume employment in their former occupation. the insured must meet the total disability requirement specified in the policy (although some disability income policies pay for partial disabilities). after a specified period following the incident that caused the disability. the ages of the group members. 4. Most group dental policies provide full coverage for examinations and preventative treatments. HMOs pay for preventative care as well as medical treatments. doctors and hospitals) for medical care to plan insureds. Very few individual dental policies are written.. To pay insured’s medical expenses b. Dental 1. G. Subscribers are usually required to select a primary care physician. 2. 255 .g. HMOs contain many characteristics of managed care plans. commonly known as HMO subscribers Subscribers must receive their medical care from within their HMO’s network of providers. 3. F. In other words. Closed panel HMOs require physicians to belong to the group under contract with the HMO before providing services to members. Open panel HMOs allow any qualified physician or provider to provide services to the HMO members. Providers within the HMO network are typically reimbursed a set fee for each service they provide. HMOs often require subscribers to pay a copayment for some services. Additionally. The primary care physician serves as the subscriber’s personal physician and refers the subscriber to any specialists that are needed. Managed Care 1. Disability income policies typically do not cover injuries that are intentionally self-inflicted or those that are caused by active participation in a war or riot. An HMO is both an insurer and a provider of health care services. Health Maintenance Organizations (HMOs) 1. To provide a medical network (e.255 5. Managed care plans require insureds to receive care only from physicians or providers that participate in the managed care network. Most dental insurance is provided through group policies. Group dental policies emphasize preventative care such as examinations and x-rays. E. 2. but deductibles or co-payments generally apply to specific corrective procedures. although some physicians receive a salary. HMOs are governed by the HMO Act of 1973. HMOs serve two functions: a. Managed care is defined as an integrated method of financing and delivering health care. 2. Some employers allow outside parties to administer their group insurance plans. which require subscribers to choose a primary care physician from within the PPOs network. Utilization Management 1. patients’ overuse of medical services is discouraged under managed care plans. 2. 256 . After a patient is released. insureds must have approval from their insurance company or care plan before being admitted to a hospital. Gatekeeper PPOs pay providers a flat amount. usually paid monthly. Gatekeeper PPOs reimburse at a higher rate if subscribers coordinate their care through their primary care physician. insureds must make notification within 48 hours of admission or face reduced or lost benefits. Fees paid for administrative service only contracts are not subject to state premium taxes. The specific process of reviewing a patient’s care is called a utilization review. 3. Utilization reviews begin with a preadmission certification. 2. Traditional PPOs offer coverage to subscribers who use out-of-network providers. Administrative service only contracts allow an insurer or other third party administrator to assume the administrative responsibilities of a group benefit plan. Except in cases of emergency. Increasingly common are gatekeeper PPOs. for each subscriber the provider serves (called a capitation rate). Preferred Provider Organizations (PPOs) 1. 2.256 3. 4. Administrative Service Only (ASO) 1. I. Insurance companies and managed care plans use utilization management to ensure that services provided to patients are appropriate and cost effective. This is known as a concurrent review. H. In other words. Preferred Provider Organizations are another form of managed care. J. traditional PPOs typically reimburse at a lower rate when the subscriber uses an out-of-network provider. However. a retrospective review takes place. Utilization reviewers monitor the appropriateness of care while a patient is hospitalized. 3. In emergency situations. 4. This review is designed to catch billing errors and to identify excessive costs. Traditional PPOs pay providers on a fee-for-service basis. PPOs are similar to HMOs in that they contract with health care providers to deliver medical services. Managed care plans have fee arrangements that encourage providers to deliver the most costeffective care possible. Individuals who administer qualified plans are considered to be fiduciaries or persons who holds positions of trust. PENSIONS Employers establish pension plans to provide employees with a monthly income benefit when they retire. ERISA requires that fiduciaries act in the best interest of the plan. Individuals may establish their IRA and Keogh accounts through insurance companies. 2. 3. fiduciaries. qualification rules. Keogh plans are individual retirement accounts that are specifically for self-employed persons. Qualified retirement plans have a nondiscrimination requirement that prohibits plan administrators from discriminating in favor of highly paid employees. 7. savings plans. Vested employees are entitled to receive benefits even if they terminate employment before retiring. The principle and interest in an IRA or Keogh fund are not taxed until the funds are withdrawn. Fiduciaries may be held criminally liable for any losses that occur because they did not adequately perform their fiduciary duties. Individual retirement accounts (IRAs) are another type of retirement plan that receives favorable treatment under federal income tax laws. 257 . Plan administrators must establish a minimum time in which an employee must be employed before being vested in the plan. There is usually a limit on the amount that employees can contribute to their retirement plans each period. A common tax-favored employee retirement plan is known as the 401(k) plan. 6. Federal income tax laws provide tax benefits to employers that provide retirement plans to their employees. The Internal Revenue Service approves qualified plans entitled to receive favorable tax treatment. Most pension plans are qualified pension plans. Employee contributions to 401(k) plans are not included as part of the employee’s gross taxable income. The Employee Retirement Income Security Act (ERISA) regulates retirement plans in the United States. Any retirement plan that is legally authorized to receive these tax benefits is known as a qualified plan. 8. vesting. A. funds are taxed when the employee withdraws them from the plan. 4. Employees who contribute to qualified pension plans do not pay tax on the contributions until the funds are withdrawn from the plan. Many pension plans are funded at least in part by employee contributions. 5. nondiscrimination requirements. Individuals can also establish their own retirement plans through products such as the individual retirement account (IRA). Qualified Plans (tax implications. prohibited transactions) 1.257 III. Qualified plans that are funded at least in part by employee contributions are known as thrift and savings plans. However. Limits are usually set as a percentage of the employee’s salary or at a specific amount or percentage based on the employer’s contributions. e. When the maturity date of the annuity arrives.258 9. The actual amounts of annuity payments are based on: a. the number of annuity payments to be made If the annuitant dies before payments begin. B. A life annuity provides benefits for at least the life of the annuitant but perhaps for an additional period. the amount of money invested b. 6. Annuities 1. An annuitant can surrender the annuity in exchange for its cash surrender value. single-premium annuity) to the issuer. Single-life annuities cover a single individual. An annuity is a series of periodic payments. The purchaser of the annuity (known as the annuitant) typically pays a single premium (i. Surrender charges usually apply only if the annuity has not been in force for a minimum period of time. An insurance company or a designated trustee is typically responsible for investing the assets of qualified plans. 4. 3. The payout period varies for each type of annuity. A temporary life annuity pays benefits for a specified period or until the annuitant dies. regardless of whether the annuitant lives or dies. A primary goal of these restrictions is to ensure the safety of participants’ investments. An annuity certain provides benefits for a stated period of time. whereas life insurance is a method for accumulating an estate. the insurer pays the annuity’s cash value to the annuitant’s beneficiaries. 258 .. Joint and survivor annuities provide a series of payments for two or more individuals until the last one dies. which equals the accumulated value of the annuity minus any applicable surrender charges. who invests these funds for a stated period and at a stated interest rate (known as the accumulation period). Annuities are considered to be the opposite of life insurance because annuities protect against the risk of outliving one’s resources. 2. Annuities contain a withdrawal provision that allows the annuitant to withdraw a percentage of the annuity’s accumulated value each year. the interest rate c. whichever comes first. the length of time the principle has been invested d. the insurer begins making a series of payments to the annuitant over a stated period (known as the payout period). 5. There is usually a withdrawal charge only if the annuitant withdraws more than the maximum withdrawal amount stated in the contract. ERISA imposes restrictions on certain investment transactions involving the assets of a qualified plan. A company’s premium can also vary based on the number of claims during a given period. Employers pay the entire premium for workers compensation coverage. PROPERTY AND CASUALTY PRODUCTS Property and casualty insurance policies protect individuals and businesses from financial loss. Variable annuities are considered to be securities contracts and are thus regulated by the federal Securities and Exchange Commission (SEC). Workers compensation pays: a. The employer must also be notified.. the majority of employees receive workers compensation coverage. Employees of the federal government receive workers compensation under the Federal Employees’ Compensation Act. Variable annuities pay a monthly benefit amount that changes as the investments (e. Individuals are protected by automobile and homeowner policies. Death benefits for survivors of employees who die because of an occupational injury of disease 2. Workers compensation policies protect an employer from financial loss resulting from an employee’s injury on the job. Workers Compensation 1. Workers compensation is a type of insurance that employers provide for employees. 5.259 7. Disability income and rehabilitation benefits for employees who become disabled through work c. A. 4. 259 . Umbrella policies provide the most extensive liability coverage for individuals and businesses. securities) purchased with the annuity’s funds rise and fall. This process of adjusting rates either up or down is known as an experience modification.g. Medical expenses for employees who are injured or who contract an occupational disease through work b. General liability policies provide additional liability coverage for businesses. In most states. except for employees who work for very small companies. Injured employees must file claims with the agency that administers workers compensation in their state. IV. Premium amounts are based on the class rating for the type of business being covered. The classifications reflect the risk associated with each type of occupation. There are several hundred class ratings used to calculate workers compensation rates. 3. Fixed annuities guarantee a minimum monthly benefit based on the size of the annuity. Each state has its own workers compensation laws. 2. Business auto policies are used to extend coverage to a company’s rolling fleet. Products liability coverage covers damages caused by products sold by a business. Benefits are usually limited. General liability insurance does not cover liabilities that a business incurs through the use of its automobiles. businesses must buy separate automobile coverage for its rolling fleet.260 B. or destroyed. 4. even if the insured was not legally responsible. Personal auto policies typically do not cover autos used for regular business purposes. General Liability 1. fire and hail damage. Medical coverage pays benefits to all passengers in a vehicle involved in an accident. 3. c. Coverage usually applies to autos mentioned in the policy’s declaration. Personal automobile policies typically provide the following types of coverage: a. Completed products liability coverage covers damages that result from work (such as repair work) done by a business. 260 . 6. as well as autos temporally used by the insured (such as rental cars or a borrowed car). 5. Other than collision insurance or comprehensive coverage covers incidents other than collision. General liability insurance covers the major liability exposures of a business. with the dollar amount of the limit set according to the premium paid. C. These incidents may include theft. not only the insured. even if that property is left in the care of the business. Automobile 1. b. The liability section also covers property damage. d. Auto coverage pays benefits in cases where the auto is stolen. Collision insurance provides coverage when the auto strikes another vehicle or object. Therefore. Liability coverage pays benefits to parties the insured injures in an automobile accident. These potential liabilities include lawsuits from public use of an organization’s facilities or products. General liability also does not cover damage to property not owned by the business. The insured’s car is also covered when other people drive it. Uninsured motorist coverage pays damages incurred by the insured and the insured’s passengers when injured in an auto accident caused by a motorist without liability insurance. or broken glass. damaged. This coverage also covers accidents caused by hit-and-run drivers. Medical payments liability coverage covers injuries to the public that occur on the premises of a business. and volcanic eruption. b. the policy would cover the cost of the emergency room visit (usually up to about $1. 3. explosion. Coverage is also excluded for individuals who use the car without believing they were authorized to do so. fine art and other items likely to be stolen. Homeowner policies provide two major types of liability coverage: a. d. Auto policies do not cover damage that is intentionally inflicted. furs. riot. Common exclusions from homeowner policies include intentional acts. the homeowner policy will pay for items such as rented rooms at a hotel.000) without the need to establish fault. Limits are usually set on jewelry. Personal liability—covers claims for bodily injury or property damage caused by the insured. if the insured’s dog bit a neighbor. restaurant meals. and war. While the home is being made livable. 261 . 2. c. such as an attached garage or carport. or a fence. wind. Automobiles are not covered as personal property under a homeowner policy. such as patio furniture. Medical payments—provides a low level of medical payment to help avoid legal action between the insured and the injured party. the policy would cover an incident where someone is injured by tripping on a crack in the sidewalk in front of the insured’s home. Homeowner policies combine property and casualty coverage into the same policy (known as multi-line policies). most auto policies will protect the insured by raising the level of benefits payable to the higher level. flood. 3. and laundry expenses. D. hail. 4. Homeowner policies provide four major types of property coverage: a. earthquake. Other buildings or structures—covers unattached structures such as a tool shed. theft. Dwelling—covers the house and attached structures. For example. a swimming pool. vandalism. For example. lightening. b. Loss of use—provides additional living expenses when the home is unlivable so homeowners can continue to live comfortably. Homeowners 1. negligence. regardless of whether on not the insured is legally liable for the incident. Personal property—covers the contents of the house and other items. In cases when an accident occurs in another state with higher liability limits.261 2. Homeowners have the option of buying additional coverage on valuable personal items. Broad form policies provide coverage for loss due to causes such as fire. The liability limit for an umbrella policy is usually high—often $1 million or more.262 E. known as a self-insured retention. However. may apply. 262 . the self-insured retention is usually higher for a commercial umbrella policy—often $10. Personal umbrella policies are designed to provide coverage if losses exceed the limits of a basic homeowner or automobile policy. 2. Umbrella Coverage 1. Commercial umbrella policies are similar to personal umbrella policies. A small deductible.000 or more. 263 STUDY QUESTIONS FOR VOLUME 3 INSURANCE INDUSTRY 1. The “combined ratio” of an insurance company is the ratio from combining which of the following? I. II. III. IV. A. B. C. D. The “loss ratio” The “other underwriting expense ratio” The “expense ratio” The “IBNR” I and II only I and III only III and IV only I, II, III, and IV 2. A plan participant’s right to receive partial or full benefits under a private retirement plan even if the participant terminates employment prior to retirement is referred to as A. B. C. D. contributing accumulating vesting non-revocation 3. Which of the following are duties of Insurance Commissioners in regulating insurers? I. II. III. IV. A. B. C. D. Rule of the constitutionality of insurance laws Determine if an insurer meets the requirements to obtain a license Render decisions on the meaning of policy terms Conduct financial investigations of insurers operating in the state I and II only I and III only II and IV only I, II, III, and 263 264 4. You are auditing the claim handling of your branch office. You note that one of the claims is for lost revenue due to a windstorm damaging the building. The claim file states that the insured requested coverage for this type of loss. However, the independent agent failed to request the coverage through an oversight. Which action is required to appropriately handle the claim? A. The claim should be denied since coverage was never present, and the claim should be placed against the agency’s Errors and Omissions policy for reimbursement of the claimant. B. The claim should be accepted and paid up to the policy limits since the insured meant to create coverage for business interruption. Due premiums for the coverage can be charged retrospectively. C. The claim should be denied since repaying for business interruption and lost revenues would financially enrich the insured, which is against one of the principles of insurance. D. The claim should be paid and the insured indemnified since the insured requested the coverage. Since the producer was acting as an “agent” of the carrier, they commute their liability. 5. Which of the following accounts would NOT be found on a life insurance company’s statutory financial statements? A. B. C. D. Nonadmitted assets Nonledger assets Deferred acquisition costs Policy loans 6. Recent activities in the marketplace have caused your company to comply with requests from 50% of your policyholders to cancel their policies. The company complies and refunds them amounts due. Your audit of this should ensure these refunds were charged against what account? A. B. C. D. Incurred but not reported (IBNR) Unearned premium reserve Goodwill Allocation for uncollectible accounts 264 265 7. Which two of the following characteristics apply to universal life insurance policies? I. II. III. IV. A. B. C. D. To provide the insured with a number of investment options To provide the insured with a minimum guaranteed cash value To provide a cash value fund that accumulates tax deferred To provide flexibility of both premium and death benefits I and IV II and III III and IV I and III 8. Which of the following are NOT common funding vehicles used by insurers to invest retirement plan assets as they are accumulated? A. B. C. D. Group deferred annuities Deposit administration contracts Separate account contracts Keogh plans 9. A manufacturer wants to protect the company from financial loss resulting from third party lawsuits. The manufacturer has learned of several recent jury awards over $7 million for product defects. The manufacturer currently has only $5 million in this type of coverage. The manufacturer has also learned that several automobile claims have been recently awarded against other company’s cars in accidents over $1 million. The manufacturer has only $5 million in coverage for automobile insurance. These events have damaged his competition and the manufacturer wants to protect his company further than the current policy allows. What insurance coverage product will the manufacturer likely buy? A. B. C. D. A personal injury protection (PIP) policy to protect others from personal injury. An umbrella policy to place a protective umbrella over existing coverage. A surplus lines policy to protect against claims in surplus of the policy limits. A floater policy to float coverages where needed. 10. The two most common types of commercial insurance companies are A. B. C. D. sole proprietor and stock equity and debt stock and mutual partnership and corporation 265 266 VOLUME IV SECURITIES 266 267 CORE COMPETENCY NUMBER FOUR: SECURITIES INDUSTRY UNIT 1: FINANCIAL MARKETS In order to understand the trading of negotiable securities, it is necessary to understand the financial markets. The items covered in this section are: A. B. C. D. Overview The Stock Exchanges Over-The-Counter (OTC) Market Options Market A. Overview Negotiable securities trade in specific markets. These markets, as well as specifics about the particular markets, are covered in the following section: 1. Brokers and Dealers - Although they perform similar functions, brokers and dealers actually perform a separate and distinct function. The securities market must be liquid to function. That means that orders to buy and sell must be processed (filled) at all times; this is called “making a market.” Dealers are expected to maintain an inventory of each security in which they make a market. Therefore, dealers are expected to have specific securities to sell if a customer wishes to buy them, and conversely, to buy these securities if a customer wishes to sell. Dealers make their money through the “spread” - which is the difference between the “Ask” and “Bid” prices. The Ask price is the price at which the dealer will sell a security. The Bid price is the price at which the dealer will buy a security. The Bid price is always lower than the Ask price. For example, a dealer may market Stock A in the following fashion: Bid (10) and Ask (10.5). Thus, the spread or dealer profit is 0.5 point for each share bought and sold. On stock exchanges, dealer firms are generally called specialist firms and have the sole (are the only ones who may sell) market for specific stocks on an exchange. The specialists deal with retail members or “brokers” of an exchange. Brokers are the middle person between dealers and the public. A public customer places an order with a broker and the broker executes the trade with a dealer. The broker receives a commission for the transaction from the public customer. 267 268 Dealers and brokers must be independent from each other. Additionally, dealers are prohibited from dealing directly with the public, except in the Over-The-Counter (OTC) market where a firm may perform either function, but cannot perform both on the same transaction. These firms are referred to as Broker/Dealer firms in the Over-The-Counter Market. The OTC market will be discussed later in this Unit. 2. Types of Markets - Negotiable securities are traded in specific markets, primarily the primary and secondary markets. The Primary Market is the market where new issues are sold. A new issue is a previously unissued security that is being sold to the public for the first time. Most new issues are traded in the OTC market, since the stock exchanges have more rigorous listing requirements. Transactions on the primary market are performed by an underwriter (the investment banking firm that is backing the transaction). After a security has been properly registered and priced in the primary market, it may be traded on the secondary market. The Secondary Market is the market that promotes the trading (buying and selling) of issued securities. There are several component markets that comprise the secondary market. They are: • • First market - where listed securities are traded on the floor of a stock exchange. The largest first market is the New York Stock Exchange (NYSE). Second market - is the trading of securities that are not listed on an exchange, i.e., (OTC). The secondary market actually has a greater trade volume than the exchanges and trades a greater number of companies. The OTC market is controlled by the National Association of Security Dealers (NASD). The market is generally called NASDAQ, which stands for NASD Automated Quotations. Third market - is the trading of listed securities (first market) which generally takes place outside of exchange trading hours. Third market companies stay open 24 hours a day and can perform trades of listed stocks even though the stock exchange is closed. Fourth market - is the direct trading of securities between institutions without a broker. This reduces the commissions paid to brokers by institutional investors (i.e., pension systems, mutual funds or insurance companies). • • 3. Types of Orders - an order is the mechanism that is used by a registered representative of a broker to execute the trade for a public customer. An order ticket is used by a broker to convey the information to exchange floor traders (specialists) or OTC traders. Information that is included on an order ticket includes: • • • • • • Customer name and account number Date submitted Buy or Sell indication Order size (number of shares) Name and symbol of security being bought or sold Price information (specific pricing information discussed below) 268 therefore. assuming that stock A’s current market price is $20. a buy limit order for $18 is an order that will only be executed if the price drops to $18. A sell stop order will not be executed until the market price reaches a specific target. Once a trade is made at $20 the sell order is triggered and is executed as a market order (thus. Market orders do not carry over to the next day. A sell limit order is similar to a buy order except the public customer is hoping the market price rises. they are placed below current market levels. corporations often issue new securities. In most cases. There is no price specified on a market order. Once a trade is made at $20 the sell order is triggered and is turned into a limit order that will only be executed if the market price is $18 or higher. In these cases. To illustrate this. a sell limit order for $22 is an order that will only be executed if the price rises to $22. Although corporations can sell their own securities to investors. they usually work through an investment banking firm. New Issues . Similarly. assume stock A’s current market price is $20. Limit orders specify a price at which a security should be bought or sold. Stop orders are orders at specific prices that are used to limit losses on long and short positions. Buy stop orders are used to limit losses on short positions (the public customer sold stock that they do not own and must deliver (buy the stock they sold) by a specified date) in rising markets. Investment bankers often underwrite (buy the securities and resell them) the new issue. a buy stop order will not be executed until the market price reaches a specific target and the trade is triggered the same as a sell stop order. Investment banking firms act as an intermediary between the corporation seeking capital and the individual or institutional investors. Note . assume a sell stop limit order was placed on stock A with a stop of $20 and a limit of $18. The dollar amounts of these transactions are very high and the investment banking business is 269 .in many instances limit orders are submitted as “good till canceled” (GTC) to stop the order from being canceled at the end of the day. limit orders will either be a buy or a sell limit order.269 • Duration of the order (unless specified all orders not executed are canceled at the end of the day) There are four basic types of orders: Market orders are orders that are to be filled (executed) immediately at the current market price. the actual price could be higher or lower). To illustrate this. 4. To illustrate this. they are placed above current market levels. let’s assume a sell stop order was placed on stock A at a price of $20. Sell stop orders are used to limit losses on long positions (the public customer actually owns the stock) in falling markets. To illustrate this. therefore. A buy limit order would specify a target price for a security.are used by corporations when they need to raise capital for long-term needs. Stop limit orders are similar to stop orders except that the order does not become a market order and must be filled at the limit price or better. An amendment to the registration statement. There are multiple requirements and conditions regarding good delivery. This prospectus contains information similar to the SEC registration document. Proceeds from primary offerings generally go directly to the issuer. there are some securities that sell for a premium on the secondary market immediately after initial issue. The following day the issue is effective and may be sold. the investment banking firm may need to stabilize the issue by buying back shares at a price below the initial public offering. Depending on the market demand for an issue. a number of internet-based companies fell into this category and the price on the secondary market rose substantially. For example. The IPO is the first time that shares of a company are offered publicly. There are generally two types of offerings: Primary offering . setting the price must be messengered to the SEC. commercial banks are prohibited from entering into the investment banking arena. In the late 1990s. the security must be registered with the Securities Exchange Commission (SEC). Secondary offering . in accordance with the laws of that state. The security also must be registered in each state in which it will be sold.is the process of delivering to the buyer and paying the seller for securities. Before a new issue can be sold.when the investment banking firm distributes securities (often large blocks) held by individual owners. The SEC has a minimum of 20 days (called a cooling off period) from registration to perform a review. This is called a tombstone announcement. This is the result of the demand for the new issue exceeding the supply. While the SEC is performing its review. a preliminary prospectus (red herring) may be issued to provide information to potential investors. a registered security must be “assigned” or properly endorsed on the back of the certificate exactly as indicated on 270 . Due to the high risk. Clearing and Settlement Process . The securities must be delivered in “good” form to clear the deal. All buyers must receive a final prospectus prior to buying a new issue. 5. This provides for full disclosure about the company and new issue to prospective investors. an expected price range may be indicated . On the other hand. At the end of the cooling off period a meeting is held between the investment banking firm and the responsible officers of the corporation to establish the public offering price of the issue. The investment banking firm announces the new issue to the press.270 extremely risky.called the initial public offering or IPO. Although a price may not be set in either the registration document or the red herring. 366 seats. enforces rules. If the new issue is canceled. they may conduct business if a partner in the firm holds a seat. • Seller’s and Buyer’s option . then the original trade is canceled. This is associated with a new issue and the certificates are not available on the transaction date. • When. and If Issued (WAII) .a next business day settlement.in both of these cases the settlement date is extended beyond 3 days at the request of seller or buyer. Seats are sold to any qualified person and prices range from thousands to millions of dollars.the settlement is postponed until 3 days after certificates are issued. usually before 2:30 pm EST. • Memberships on the NYSE are limited to 1. they do have an enforcement role to ensure that trades conform to laws and regulations.a same day settlement. B.Although exchanges are not involved in the market.S. The Stock Exchanges * A stock exchange is the location where buyers and sellers trade securities. An exchange board of directors sets policy. it should be noted that regional stock exchanges function in a similar manner. Government securities . however. The board is comprised of an equal number of members (see below) and the general public. The board also includes an elected full-time chairman. If certificates are held by a brokerage firm (in which the holder has signed the power of transfer to a brokerage firm) the certificate can be transferred without a signature.271 front of the certificate. * To simplify discussions of exchanges most of the examples will be related to the NYSE. The largest and most widely known stock exchange is the New York Stock Exchange (NYSE). municipal bond and corporate bonds is three business days after the transaction date. corporations and partnerships may not hold seats. • U. The settlement date for stock. As. This is called the regular way transaction. Categories of memberships are: 271 . 1. It should be noted that the NYSE handles over half of all securities transactions. Other stock exchanges include: • The American Stock Exchange • Midwest Stock Exchange • Pacific Stock Exchange • Philadelphia Stock Exchange • Boston Stock Exchange All of these exchanges function in a similar manner and listed securities must be traded in the physical boundaries of the exchange floor. These memberships are open only to individuals. and handles memberships. How the exchanges function . Although brokerage firms are not permitted to hold a seat. Other settlement dates are: • Cash . determines which stocks will be listed. to be listed on a stock exchange a company must meet specific requirements that are designated by the exchange. the NYSE has some general and specific requirements (the requirements periodically change). The information on the tape is submitted by the selling broker and includes the number of shares and price. To delist a corporation on the NYSE. The consolidated tape . holders of no more than 10% of the outstanding shares may object. 3. two-thirds of the common stockholders must vote to delist. There are three tape networks: • • Network A .these members stay in a particular floor location and are involved only in trades in which they specialize. The requirements for listing on the NYSE include: • • • • • • • • • A minimum market value A minimum number of outstanding shares A minimum number of shareholders A minimum threshold for corporate earnings Financial condition of the corporation Future prospects of the corporation Corporation must permit full voting rights to common shareholders Corporation must provide relevant information to investors on a timely basis The NYSE Board also determines if there is sufficient national interest in the corporation Delisting can occur if the corporation falls below the minimum listing requirements described above.these members usually executes trades only for their own account. Listing and delisting rules .covers all stocks listed on the NYSE and includes all trades of the listed stocks (including regional exchange transactions and third and fourth market transactions) Network B .272 • Commission house brokers . file for bankruptcy. • Registered trader . 2. • Bond members .these members deal exclusively in bonds. • Market Maker or Specialist . Only listed stocks can be bought and sold at the exchange. 272 .the members generally execute customer orders for a fee or commission.these members generally execute orders for other brokers when they are too busy. A corporation may request an exchange to delist them. For example. Additionally. or fail to disclose financial statements.covers American Exchange (AMEX) transactions and trades from regional exchanges of stocks listed on the AMEX or NYSE. a corporation can be delisted if they disallow common stock voting rights. • Floor brokers . They may also execute trades for their own account.stock transactions are shown on a tape within seconds of a transaction. and a majority of the corporation’s board of directors must agree to the delisting. • If a stock opening is delayed. Trading limitations based on market volatility (rules 80A and 80B) – after the market crash in October.provides quotes on exchange listed securities traded in the OTC market. which is listed at the exact amount. the NYSE instituted these rules to decrease market volatility. Specific rules relating to the NYSE – beyond the listing and delisting rules discussed in section 2.” The firm must first send the trade to the exchange floor and if the order is not taken. the tape would have ‘TRADING HALTED’ next to that particular stock. A list of some of the NYSE trading rules follow: • • Prohibition of prearranged trades (rule 78) – prearranged trades to sell securities with an offer to buy back at a stated price is prohibited. Rule 80A reduces computerized institutional orders by routing them to a specialist for approval. Rule 80B halts trading for all stocks for 1 hour if the DJIA declines by 250 points.000. • If trading is halted. Prohibition of crossing orders within a firm (rule 76) – a member firm holding a sell order and a buy order from two customers is prohibited from making the trade “within the firm.100 shares of IBM at $110) (900 shares of IBM at $108 sometime earlier) (500 preferred shares of IBM at $150) 4. If after trading reopens on that day and the DJIA decreases another 150 points. • 273 . trading is halted for 2 hours. • Trades that are reported late are listed with ‘SLD’. This rule is invoked if the Dow Jones Industrial Average (DJIA) moves by 50 points or more or if the Standard and Poor’s 500 Index moves by 12 points or more. with the exception of trade volume over 10. • Share price is listed in the dollar amount with the minimum value being one sixteenth of a dollar. the tape would have ‘OPD’ or ‘OPENING DELAYED’ next to that particular stock. The tape contains the following abbreviations and symbols: • Ticker symbol or abbreviation for the stock is listed at the top of the line (for example International Business machine is listed as IBM). 1987.273 • Consolidated quotation services . the NYSE has trading rules to ensure that the market functions effectively and that members and brokers do not have an unfair advantage over the public. Some basic examples of tape information follow: IBM 11s110 SLD 9s108 5sPr/150 (1. then the firm may complete the trade within the firm. • Preferred stocks are identified with a Pr. • Trades are listed in multiples of 100’s and followed by an 's'. stm) • Boston Stock Exchange (http://www.com/) • Pacific Stock Exchange (http://www. Regional Stock Exchanges . OTC prices are negotiated. Some of the regional stock exchanges and their Internet web sites as of (August 1999) are listed below: • The American Stock Exchange (http://www. someone who wants to buy a security will make a bid (set a price at which they will buy a security) and someone wishing to sell will ask (set a price at which they will sell a security) for a price. the OTC market is generally called the second market (note it is also sometimes called the third market). • All types of issues are traded OTC. How the OTC functions – Unlike exchanges where prices are determined by bidding conducted on the floor. mutual fund shares. The difference between the bid and ask is the spread.com/index.com/) • Philadelphia Stock Exchange (http://www. government bonds and corporate bonds are all traded in the OTC market. which is listed at the exact amount is used to describe securities trading that does not take place on the floor of an exchange.A stock exchange is the location where buyers and sellers trade securities. Trade records retained for 3 years (rule 410) – records of trade orders transmitted to the floor must be retained for 3 years with 2 years worth of these trades readily accessible.com/) These exchanges perform the same function as the NYSE. There is no centralized location and individual firms “make a market” in a specific set of securities.000. listed and unlisted securities.. Over-The-Counter (OTC) Market As outlined in section I. bank and insurance company shares. C. 1. All securities not listed on an exchange are traded on the OTC market.phlx. The term Over-The Counter's'. however. For example. Firms are prohibited from the following activities (rule 435) – • Trading an account too frequently or trading an excessive amount in proportion to the account • Participating in any customer manipulation • Circulating rumors to influence market price • Changing the price of a transaction before the settlement date 5.bostonstock.pacificex. For example. with the exception of trade volume over 10. any stock may be traded OTC.amex.A.274 • • • Customer orders must receive priority over firm orders (rule 92) – a customer’s order must receive priority over an order for the firm’s trading account for anyone associated with the firm. Some of the particulars of the OTC include: • OTC transactions are governed by National Association of Securities Dealers (NASD). but deal in smaller volumes. 274 . government securities. • Smaller and newer companies tend to trade on the OTC (since they generally can’t meet the exchange listing requirements). • Require quotes for each issue. they can not act a dealer and broker on the same transaction (i.e. but has the option to do so.. How the options market functions – To understand the options market. NADAQ includes 3 levels of quotes. • Long – A term used to describe the position of the holder (buyer) of the contract. there are specific requirement for NASDAQ listing. The requirement for listing a security on NASDAQ include: • Registration under the Securities Act of 1934 or the Investment Company Act of 1940. • Require net capital position of at least $2. Brokers must send written confirmations to the customer (for retail customers. • A minimum of two market makers for domestic companies and three for foreign companies. the securities must be sold or bought at the specified price. The individual who buys a contract is not required to finalize the trade. however. 2. earn a markup and charge a commission).00 per share. D.275 • • • • A market maker (dealer) makes money through the spread (or markup) rather than through a commission. • Require daily and monthly reporting regarding trading volume. Options Market The options market provides an opportunity to enter into a contract to buy or sell securities for a set price until a specified date. • A minimum of $1 million to $2 million in capital and surplus. Brokers act as an agent for a buyer or seller and make money through commissions. • Report trades within 90 seconds of execution. • Level 3 – for the use of market makers and permits the entry of their current quotes. Listing and delisting and other OTC rules – Although not nearly as stringent as the listing requirement for an exchange. • Level 2 – provides a listing of all market makers and their current bid and offers. If the buyer exercises the option. • A minimum of 300 stockholders.500 on each issue. • A minimum of 10. 275 . Market makers on NASDAQ also have specific rules that they must follow. • A minimum price of $5. 1. confirmations must be sent on the settlement date). These requirements include: • Maintain business hours of at least 8:30am to 4:30pm (Eastern Standard Time).000 publicly held shares. • Level 1 – for retail customers and includes the highest bid and lowest offer for a security. Dealers may also be brokers. some basic terms must be defined. In example 2 the writer has a break-even price of $37 [($40x100 shares) . The writer of a call has the same break-even point when writing an uncovered call (the writer will buy the stock at the time of the transaction).300= $3500/100 shares = $35/share]. If stock Z rises to $50 then customer X may decide to exercise the option. customer X buys the stock for $4. The holder of a call has a break-even point when the stock price equals the strike price plus the premium paid. To help explain options. In this case. Put option – the holder of the option has the option (right) to sell securities to the writer for a specified price. brokerage fees are omitted from the break-even analysis. Customer X would realize a profit of $500 ($4. two example are listed below: • Example 1 – (Call Option) . Using example 1 outlined above and adding the writer’s original purchase price $38. If the call is covered (the stock has already been purchased) then the break-even analysis is a little more complex. The writer of a put has a breakeven point when the stock price = strike price – premium received.200 ($32 x 100). Example 2 – (Put Option) .000 – $4.276 • • • • • • Short – A term used to describe the position of the writer (seller) of the contract.000 ($40 x 100) and then sells it for $5.$300 = $700). 276 .300= $3700/100 shares = $37/share].000 . If stock Z rises above $40. Customer X would realize a profit of $700 ($5. The premium is paid whether or not the option is exercised. Premium – the fee paid to the writer of an option by the holder.$300 = $500).200 .000 ($50 x 100). then customer X will let the option expire and lose the $300 premium. If stock Z falls below $40. In this case. customer X sells the stock for $4. Expiration date – the month (date) in which the option expires. If stock Z falls to $32 then customer X may decide to exercise the option. Strike or exercise price – the specified price included in the contract. • One way to analyze options is through a break-even analysis* for the holder and writer. the break-even price is $43 [($40X100 shares) + 300= $4300/100 shares = $43/share]. Using example 1 outlined above.300= $3700/100 shares = $37/share]. Call option – the holder of the option has the option (right) to buy securities from the writer for a specified price. then customer X will let the option expire and lose the $300 premium.Customer X buys an option for the month of January to buy 100 shares of stock Z at $40 per share for a premium of $300.Customer X buys an option for the month of January to sell 100 shares of stock Z at $40 per share for a premium of $300. The holder of the put in example 2 has a break-even price of [($40X100 shares) . the break-even price is [($38x100 shares) . * Note: For simplicity.000 ($40 x 100) and buys it for the sale $3.000 – $3. The holder of a put has a break-even point when the stock price equals the strike price minus the premium received. E. C. Issued stock – the number of shares sold to investors. Common Stock Preferred Stock Warrants Debt Securities Options • • • • • To assist investors. 1. Corporations often hold in reserve some shares (unissued) for future use. Treasury stock – the number of issued shares that have been acquired by the corporation. Market value – the current price of a share in the market. This helps investors determine if a particular stock meets their financial objectives. It is usually a low number and does not have a relationship to the actual value of the stock. DEBT SECURITIES. D. OPTIONS. NEW ISSUES Negotiable securities traded in the primary and secondary market can be divided into five basic categories. Common Stock Common stock is the term used to identify a unit (share) of ownership in a corporation. Corporations are legal entities that are chartered under the laws of the state in which they are incorporated. They are: A. A limit on the number of shares is usually listed in the articles of incorporation. a 30277 . Par value – a value that is printed on the stock certificate. Common stock is the means for an individual or group to have ownership in a corporation with limited liability. Outstanding stock – the number of shares currently held by the public. For example. A. Note: treasury stock is not generally included in this calculation. Note: the number of shares of treasury stock plus the number of outstanding shares should equal the number of issued shares. Note: issued stock may not exceed the number of authorized shares. Unissued stock – the number of shares that have not been sold. Terms and definitions – To understand the common stock principles.277 UNIT 2: EQUITIES. some additional terms have been developed to classify stocks. B. The number of unissued shares can be determined by subtracting the number of issued shares from the number of authorized shares. some basic terms must be defined: • • • Authorized stock – the number of shares permitted to be issued. Book value – a value determined by taking the net worth of the corporation divided by the number of outstanding shares. Treasury stock does not have voting or dividend rights. These corporations generally reinvest earnings rather than pay dividends. • • • • • 2. although all stockholders have the same rights. an individual with 100 shares generally has 100 votes and likewise a person with 100. there is correlation between the number of shares held and rights. Speculative stocks – relatively new corporations that have poor earnings records but have the possibility for capital gains. Stocks in the utilities industry are generally considered income stocks. As a result. • Changes to the corporate charter.000 votes. As outlined below. • Mergers and acquisitions.278 year-old investor may be fairly risk tolerant and interested in a growth stock that may appreciate over time. Blue chip stocks – corporations that are well-established and have a historical record of strong performance and earnings. Some classification terms include: • Growth stocks – corporations that are in a growth mode and are projected to grow rapidly. preferred stock. These stocks can have excellent growth and income potential. These issues include: • Election of the board of directors (the officers of the corporation). individuals who hold large blocks of shares are more likely to be board members. Stocks in startup Internet companies are generally speculative. Defensive stocks – corporations that are historically unaffected by the economy and business cycles. Stockholder or shareholder rights include: • Voting rights – most corporations have an annual meeting where stockholders have the opportunity to vote on important issues. all corporations are required to 278 . • Recapitalization (to exchange stock. • Proxy rights – most shareholders. Although voting procedures vary.000 shares has 100. while a 65-year-old investor may be less tolerant for risk and interested in an income producing stock that is less volatile. These stocks are extremely risky as many such companies will not prosper. The most common issues voted on are the election of the board of directors and proposed changes to the charter. For example. • Reorganizations. Income stocks – corporations in established industries where the market price is less volatile and a large portion of earnings is paid in dividends. the prospect for astonishing returns makes them a viable investment for risk takers. there is a relationship between the number of shares held and votes. and as such have certain rights of ownership. Rights of common shareholders – stockholders are the owners of a corporation. however. or a bond to another type of security). As a result. particularly those with modest holdings are unable to travel to and attend annual meetings. Cyclical stocks – corporations that historically have returns that mirror the economy. Investors are hoping for long term capital appreciation (the market price significantly increases). 000 shares at $25 per share after a 2 for 1 stock split. Stock splits – if a corporation wants to reduce the price of a share of its stock. corporations may provide shareholders with additional shares of stock. For example. it may authorize a stock split. As outlined below. Stock dividends – rather than giving cash to investors. however. Dividends are often paid quarterly. some basic terms must be defined: 279 . a dividend of $1. As noted in the example. A stock dividend is usually declared as a percentage. However. shareholders have the rights to any assets remaining after liabilities. Pre-emptive rights – although these rights do not always exist. They are several types of dividends: • Cash dividends – cash payments declared as a particular dollar amount for each share owned. This process is often used during a hostile takeover where an external group tries to take control of a corporation by replacing the current directors with their own. 1. shareholder meeting minutes. preferred stockholders generally receive a fixed dividend rate and preferred stock generally has par value of $100.00 per share would pay $500 to a shareholder with 500 shares of stock. A common practice permits the shareholder to return a proxy card with specific voting directions. bondholders. For example. then he or she would have the right to buy 5% of newly issued shares. Shareholders also have the right to receive declared dividends. they are also paid semiannually and annually. Inspection rights – shareholders have the right to inspect certain records such as accounting records. Besides the potential for capital appreciation. Liquidation rights – if a corporation is dissolved. and preferred stockholders are paid. an investor with 500 shares of stock selling at $50 per share would have 1. and lists of all shareholders. the investor’s net share value remains the same.279 • • • send all shareholders a proxy. A proxy can allow the holder of the proxy to vote the shares on behalf of the shareholder. investors also have the potential to receive dividend income. If a person owns 5% of a corporation. For example. • • B. annual meeting minutes. at the time of the split. Preferred Stock Preferred stock is similar to common stock in that it represents ownership in a corporation. a 5% stock dividend for the shareholder with 500 shares would provide the investor with 25 additional shares of stock. if they do shareholders are entitled to buy any new issue of stock in proportion to their holdings. preferred stock is in many ways more similar to a bond than to common stock. A shareholder can allow the proxyholder to vote the shares as he or she wishes or provide specific voting instructions. Terms and definitions – To understand the preferred stock principles. which is effectively a power of attorney. preferred stockholders accumulate payment rates and must be paid in full before any dividends are paid to common stockholders. Although generally attached to bonds or preferred stock. 2. Preferred stock generally costs more than common stock because of the additional rights preferred stockholders receive. Participating preferred stock – additional dividends are paid to preferred stockholders (above the fixed percentage) if dividends declared to common stockholders exceed a pre-determined threshold. some basic terms must be defined: • • • Warrants are generally attached to a bond or preferred stock and carry the right to purchase common stock at a fixed price. Convertible preferred stock – the shares of preferred stock can be exchanged for common stock at a pre-determined rate. Detached warrants can be traded and have their own value based on the current market and exercise prices. 280 . The price of convertible preferred stock tends to mirror the price changes associated with the common stock. In addition. if dividends are not declared by the board of directors in a given period. In addition to the features listed above. a corporation could sell convertible. Warrants Warrants are similar to options as they provide the holder with the right to purchase a share of common stock at a fixed price (called the exercise price). Preferred stock prices and features – As outlined in the previous section. Non-cumulative preferred stock – If dividends are not declared. These features impact the price of preferred stock. Callable preferred stock – the corporation reserves the right to purchase the stock from the shareholder at a pre-determined price. preferred stockholders have specific rights. Warrants typically expire after a number of years. It should be noted that these types of preferred stock can be combined. C. In general. preferred stockholders will be paid prior to common stockholders in the event of a liquidation or bankruptcy. preferred stockholders are not granted preemptive rights. preferred stockholders lose their dividend rights for that period. Dividends are generally a fixed percentage or dollar amount.280 • • • • • • Preferred stock – has ownership rights and usually has par value of $100 per share. For example. preferred stock has some specific features. As outlined below. 1. If a warrant is not detachable it has no individual market value. a corporation can sell multiple classes of preferred stock. warrants can also be attached to other securities. cumulative preferred stock. Cumulative preferred stock – since the dividend rate is fixed. such as speculative stock. Terms and definitions – To understand warrants. Warrants allow holders to buy more stock as its value appreciates. The transfer is completed when the new holder is listed on the bond issuer’s records. Coupon bonds are generally clipped twice a year. • Current yield – since bond prices fluctuate based on market conditions. a warrant is relinquished in return for shares of common stock at the exercise price. For example. This is currently the most common form of bond since it reduces costs. Bond yields – there are three different ways to determine the return (yield) on a bond. a $1. and bond prices rise as interest rates fall. fixed interest debt obligations. bonds have a par value (normally $1. Registered bonds – are registered in the owner’s name on the issuer’s records. Interest payments are sent directly to the owner.000) and a market value that fluctuates based on market conditions. The call provisions outline the possible date of the call and the price. the seller must endorse the certificate and send it to a transfer agent who cancels the old certificate and issues a new one. Bonds are long-term. Issuers usually call bonds when interest rates significantly decrease or to change the bond maturity date. Coupon bonds – have actual coupons attached to them that must be “clipped” and sent to the paying agent for interest payments. 1. some basic terms must be defined: • • Bond – contract between the issuer and investor that provides the issuer with immediate capital in return for a promise to pay back a given amount at given date and to pay interest at a stated rate throughout the life of the bond. however. To most people debt securities are synonymous with bonds. will continue to exist until they reach maturity. the investor in equity securities becomes a part owner of the company. If a registered bond is sold. those previously issued.281 • When exercised.000 par value bond with a nominal yield of 10% would return $100 per year. This is also called the coupon rate. Callable bonds – are bonds that have “call provisions” that give the issuer the option of calling (redeeming) the bond before the maturity date. Bearer bonds have not been issued for the last couple of decades. • Nominal yield – the rate of return stated on the bond. Bond pricing . These bonds must be kept in a safe place since the certificate and coupon are the only proof of ownership. The price of previously issued bonds has an inverse relationship to market interest rate changes. a bond 281 • • • • • • • . Bearer bonds – similar to coupon bonds in that ownership is based on possession. Debt Securities Debt securities are another major category of investment securities. D.similar to stocks. Terms and definitions – To understand debt securities. Putable bonds – similar to callable bonds except the owner has the right to redeem a bond before the bond maturity date. Bond prices fall as interest rates rise. however. Book-entry bonds – no certificate is issued and computer based records of ownership are retained. For example. Debt securities differ from equity securities in that the investor in debt securities becomes a creditor of the company. the current yield is based on the current price of the bond. A trustee (most often a commercial bank) is generally appointed to ensure that the obligations defined in the agreement are carried out. These include: • 1st mortgage bonds – give bondholders claim against real property. and the paying agent (either the corporation or a trustee). they are honored before a stockholder’s claim on assets. The exact computation of yield to maturity is complex and is usually left to bond tables. Bond quotations – bonds are generally quoted on yield to maturity to make it easier to compare bonds with the same maturity date.282 • currently priced at $1. Secured bonds – bonds that are backed by “real” assets.250 with a 10% nominal yield of $100 would have a current yield of 8%. These include: • Debentures – backed by the “good faith and credit” of the issuing corporation. In addition. special features. If at maturity a bond were selling for par ($1. if at maturity a bond were selling for less than par value. bondholders’ claims receive priority over stockholders’ if corporate assets are liquidated. interest payment dates. then the yield to maturity would equal the nominal yield. The same bond priced at $800 would have a current yield of 12. interest rate. the investor would also receive the difference. Bondholders do have some specific rights such as the corporation’s obligation to pay interest. maturity date. This is the most secure type of corporate bond since it is has priority for claims on assets. • Subordinated debenture . Unsecured bonds – bonds that are not backed by assets and provide no claim on assets for bondholders. 2. An investor would lose the difference on a bond selling for over par value. Bondholders are considered creditors and unlike equity investors are not owners and have no voice or votes in management decisions. • Collateral trust bonds – are backed by marketable securities held by a trustee. interest on bonds must be paid before any stock dividends are paid. However. • • 282 . face value of the bond. These are often stocks and/or bonds of corporations other than the bond issuer. Corporate debt – Corporations issue debt (bonds) to obtain capital for long term use. • Yield to maturity – the return on the bond if it is held to maturity. Trust indenture – a contract that supplements the bond contract that is required by the Trust Indenture Act of 1939. Some basic terms and definitions for corporate bonds include: • • Bond certificate – shows the name of the issuing firm. For example. however.similar to debentures except they are honored after debentures on asset claims.000). The contract sets forth the terms between the corporation and the bondholders and is designed to protect bondholder’s rights. • 2nd mortgage bonds – are also backed by real property but are second in priority for claims on assets.5%. These bonds are inferior to secured bonds. A copy of the trust indenture must be filed with the SEC. Non-negotiable securities – are not transferable and can be redeemed only by the purchaser. securities firms generally do not sell them. Two types of U.000 and are sold at auction in a manner similar to that for treasury notes. U.are short-term instruments that are sold at a discount at auctions. gains are treated as ordinary income and can be deferred until redemption for tax purposes.000. Municipal debt – These government obligations or issues are issued by state and local governments. The amounts range from $1. Treasury. safe. These bonds are available in denominations from $50 to $10. US Territories. and may have tax advantages. • Treasury receipts (Strips) – were created in the 1980s. cities and airport authorities).000 to $100. They are redeemable at maturity and pay interest twice a year. the interest rate is fixed and bids are either at a premium or discount from par. however.S. Some specific types include: • Treasury bills – (T-bills) . They must be purchased at U. For tax purposes.S.000. savings bonds are classified as non-negotiable securities: • Series EE bonds – are registered bonds that are sold at a 50% discount of the face value.000 to $1. • Treasury notes – are instruments with maturities from 2 to 10 years with amounts from $1. • Series HH bonds – are registered bonds that are sold at par value with semiannual interest payments. They are also sold at auction. very liquid. The “full faith and credit of the government” back these issues. For tax purposes the difference in price is considered interest income rather than a capital gain. treasury offices or federal reserve banks. The interest payments on Treasury bonds were removed (stripped) from the bonds. These government obligations or issues are the safest form of debt security (there has never been a default). however. and any public agency or political subdivisions that are not federal (such as school districts. government is the largest borrower in the world and has a variety of debt instruments.000. The coupons (interest payment) from bonds with the same maturity date were then sold independently by the U. they are a very common investment among individual investors. Municipal debt is considered 283 . Since they are not transferable. Some terms and definitions include: • Negotiable securities – are traded continuously. • 4.5%.S. The auction winner is the bidder offering the highest dollar price. EE bonds must be used to purchase HH bonds which mature in 20 years with an effective interest rate of 7. Auctions are held weekly for 3 and 6-month issues and monthly for 12-month issues. Maturity varies depending on the interest rate and can be redeemed anytime after being held for 6 months. The groups of bonds are often called “strips” and trade as a zero coupon bond.283 3. • Treasury bonds – are instruments with maturities of 30 years for new issues (10 to 30 year issues were allowed in the past). which is in effect the lowest interest rate for the issue.S. In general these government obligations are exempt from state and local taxes.S. Government debt – The U. General obligation bonds are generally used to finance non-revenueproducing projects. Dealers sell a portion of their securities (minimum amount is $1 million) to entities with cash reserves and agree to buy them back for the principal plus interest (interest for a day is calculated on a 360 day year). Revenue bonds – are the most common type of municipal bonds and are backed by projected revenue streams from the infrastructure built by the bond. Special tax bonds – are repayable from the proceeds from a special tax. These are highly liquid instruments and a common investment form is a money market fund. Double barreled bonds – are bonds that are backed by two sources of revenue. A limited bond is backed by an issuer that has a taxing limit and is considered a riskier investment. often 1 day. If sufficient revenue is not generated. the dealer suffers a loss. Federal Reserve requirements – The Federal Reserve requires banks to hold a portion of its funds in reserve. If the market price of the instrument rises more than the interest paid. Some type of municipal bonds include: • General obligation bonds – are backed by the full faith and credit and taxing power of the issuer. and bonds that mature in less than 1 year. However. Banks in need often enter into “overnight” • 284 . certificates of deposit. banks may need to borrow funds in the short term to comply with this requirement. These include treasury bills. Revenue bonds generally have higher yields than general obligation bonds and are intended to be self-supporting. For example. Moral obligation bonds – are bonds that are backed by the projected revenue from a project. Most municipal bonds are issued to raise funds for infrastructure improvements and although default is rare. Interest is generally paid semi-annually and the most attractive feature is the exemption from federal tax requirements. These revenues can be in the form of rental or user fees for facilities or even tolls for road improvements. as a result it will usually have a higher yield. As a result. then the issuer is morally (but not legally) obligated to repay the bonds. treasury notes. government obligations. Money market debt – Short-term debt obligations (of less than 1 year) that are considered secure constitute money market instruments. the dealer realizes a profit and conversely if the interest paid is more than the rise in the instrument price. If these bonds are backed by the full faith and credit of the issuer. it can happen. • • • • 5. An unlimited tax general obligation bond is backed by the issuer’s unlimited taxing power and is considered a safe investment. Investors that are concerned about tax issues generally hold these issues.S.284 the second safest form of debt security after U. a special tax bond that is also backed by the full faith and credit of the issuer is a double barrel bond. Some examples of special taxes are taxes on liquor and cigarettes or special assessments for a group affected by an improvement. Special tax bonds are also often used to fund infrastructure projects. The repurchase date is usually very short term. then they are then considered general obligation bonds. the safety of an issue depends on the financial condition of the entity backing it. Some terms and definitions include: • Repurchase agreements – occur when a security is sold with an agreement to buy it back. These bonds are more risky and have a higher yield to attract investors.BB and below and Moody’s BA and below) are considered speculative (junk bonds). Baa) are considered investment grade bonds. These accounts are very liquid and often provide limited check writing capability as a means to redeem shares. maturity can be as short as 7 days.AAA. however.000. Standard & Poor’s (S&P) and Moody’s are the best-known independent rating firms.285 • • • borrowing with other banks or the Federal Reserve itself. 6. and BBB and Moody’s – Aaa. interest is calculated on a 360-day year.” The federal funds rate varies significantly depending on the demand for funds. The maturity date is generally 1 year. The higher interest rate compensates for the increased risk associated with depositing funds in a foreign bank. Commercial paper – are instruments issued by very credit worthy corporations and are in effect an unsecured promissory note. A. Negotiable certificates of deposit – are tradable certificates issued by commercial banks in exchange for time deposits. The opposite is true if a new issue has a lower interest rate than an existing issue. Mutual fund companies. The discounted bond is in effect being sold with the same total return as the new issue. Aa. Interest is often calculated daily and reinvested in the investor’s account at a specified interval. Effect of interest rates on bond prices – as interest rates change. The interest rate is the interbank interest that is generally slightly higher than the rate of treasury bills. Lower rated bonds (S&P . Interest is calculated on a 360-day year and this daily rate is often called the “federal funds rate. the other falls). These bonds are less risky and as result have a lower yield. A. Bond ratings – most corporate bonds have a rating from an independent firm. In this case. investors will not purchase existing bonds unless the bond is discounted (sold at a lower price) to align itself with the current interest rate. with maturity up to 270 days. AA. Money market fund – a mutual fund that invests in short term liquid securities. These ratings provide investors with information regarding the risk of default on the bond issue. These instruments are issued at a discount of the face value and have become a substitute for bank borrowing for qualified corporations. 7. Eurodollar debt – is a dollar deposited in a bank outside of the United States. The change in prices has an inverse relationship to changes in interest rates (if one rises. • • If interest rates rise – existing bond prices fall If interest rates fall – existing bond prices rise 8.000 and interest is calculated on a 360 day year. The higher rated bonds (S&P . If new bond issues are paying a higher interest rate than existing bonds. The minimum amount is $100. the price of an issued bond also changes. and banks often buy these instruments. The minimum amount is $100. insurance companies. the existing bond can be sold at a premium (sold at a higher price). 285 . Swiss francs and Japanese yen. and the price is based on the closing price on the transaction day. European Currency units. issues all option contracts. The futures market is the main trading market for securities based on interest rate movements. If the health care index above closed on the date exercised at 186. This market operates 24 hours a day. Index options – are based on stock indexes (which are weighted averages of groups of stocks). is self-regulated. Unlike a stock option.C. Some of the common currencies traded are Deutsche marks. the securities must be sold or bought at the specified price. and acts as a clearing house for all trades. both ends of the option (both the buyer and seller) settle in cash. If the buyer exercises the option. British pounds. Index options provide the opportunity to mitigate risk through diversification. Canadian dollars.C. Interest rate options – are used to speculate on direction of interest rates.286 E.C.C. Foreign currency options – are used to exchange currencies at specified exchange rates. but has the option to do so. guarantees the contracts. which is a subsidiary of the CBOE. 3. The trading of these contracts is limited. only those of larger market capitalization (NYSE listed issues). 5. Contract specifications include: • Contract size 286 . Options are not traded on all securities. Investor may trade index options for broad indexes like the S&P 500 or more narrow indexes such as stocks in a single field such as health care. Option Clearing Corp. The interbank market involves currency exchanges among commercial banks. and is dominated by major banks and corporations. then the value of one option contract is $18. The O.C. 4. Equity options – for detailed information on equity options.). If the health care index is 185.C. Options The options market provides an opportunity to enter into a contract to buy or sell securities for a set price until a specified date. please go to unit 1. they might buy a call on an index of health care stocks. rules – Options are traded on the following exchanges: • Chicago Board Options Exchange • American Stock Exchange • Pacific Stock Exchange • Philadelphia Stock Exchange • New York Stock Exchange Option contracts traded on the exchanges are standardized under rules set by the Options Clearing Corporation (O. Settlement occurs the day after the option is exercised.S. The O. Foreign currency options are traded in fixed contract sizes. Trading of options on the U. 1. The value of an index option is typically $100 times the value of the index. If investors believe health care stocks will rise but are unsure which particular stocks will rise.2. section D.4. The individual who buys a contract is not required to finalize the trade. 520. dollar in the United States is prohibited. The Philadelphia Stock Exchange trades currency options. 2. the holder would receive $120 from the seller. g. The listing provides the name of the underlying stock and its closing price that day. maintenance of records and position limits.C.C. their risks and uses. also has a set of rules by which customers and registered representatives must abide. the strike price of the option.287 • • • • • • • Strike price intervals Premium increments Expiration Date Actual Maximum Contract Life Trading Hours Trading cut-off Exercise cut-off The O. 6.. the registered representative must give to the customer an Options Disclosure document that explains basic option strategies. Listings can be divided into two categories: • Option Class – Contracts of one type on an underlying issue (e. 287 . • Option Series – Contracts of the same class with the same strike price and expiration (e. Note: any contract followed by an “r” indicates an option that is not traded. Financial listings –Options are quoted daily in the newspapers. the closing prices (premiums) of the 3 call and 3 put contracts trading closest to expiration. all calls on IBM with September expiration and 90 premiums constitute a series).. Along with detailed rules for settlement. all calls on IBM constitute a class).g. F. E. A. The following topics will be outlined in this Unit. D. • Some fund companies also provide investors with the option to exchange shares into different fund types. Basic Concepts Basic Concepts – To understand mutual fund principles. • Reinvestment options often exist. B. • Capability to diversify investment holdings with less money invested. Mutual funds provide investment diversification (even for a small investor) and professional management. C. The value of an investment company is based on the worth of its shares. These companies sell shares to shareholders and then invest those funds in a portfolio of securities. some basic concepts must be addressed: • Advantages to mutual funds: • Funds are managed by a full-time professional. and the value rises and falls based on the value of the securities.mutual funds are often quoted as bid and ask. Net Asset Value (NAV) . • Investments can be made in dollar amounts since shares can be purchased in fractional amount.the price at which the fund will redeem its shares (Net Asset Value). where the investor can automatically purchase additional shares with dividend or capital gain distributions. Bid and Ask prices . • Fund shares can often be used as collateral for loans. A.is the value of a fund share that is calculated at the close of business each day and is based on the prices of the securities held in the fund.288 UNIT 3: MUTUAL FUNDS Mutual funds are securities issued by investment companies whose primary purpose is to invest in securities of other entities. • Ask . • Bid . A shareholder then owns a portion of the securities portfolio. • Securities are maintained by the fund company. Basic Concepts Income Mutual Funds Stock Funds Growth Mutual Funds Balanced Funds Specialized Funds • • 288 .the price at which the fund will sell its shares (Public Offering Price). • Load funds have a sales charge. These funds are referred to as Class B shares. These fees are clearly outlined in the prospectus for a mutual fund and are included in the rate of return calculation for a fund.is the document that provides a general overview and description of the fund. The SEC has suggested that the following information be placed in a prospectus: • General description of the fund • Condensed financial information (including annual rate of return and fees) • Portfolio turnover rate • Key management personnel • Synopsis of the investment objectives and restraints • How to purchase and redeem shares • Pending legal proceedings Operating fees and costs . commissions paid to brokers for stock trades. are referred to as Class C Shares. The primary objective of an income fund is to produce a steady stream of income for the investor rather than an appreciation in the value of shares. A mutual fund that invested primarily in utility companies and bonds would be an example of an income mutual fund. and advertising services. The intent is to provide a potential investor with enough information to make a sound financial decision. and fees for legal. Income Mutual Funds Income mutual funds are funds that invest primarily in income producing securities. • • B. therefore. These funds are also purchased with the aid of a broker/dealer. Sales charges are imposed only when fund shares are sold to an investor (Commonly referred to Class A shares). which accounts for the difference between the bid and ask price. Funds that charge redemption fees. • Contingent Deferred Sales Charges – some funds charge a sales charge at time of redemption.are the two broad categories of fund types. accounting. 289 . Load and No Load Funds . • Redemption fee . These funds are purchased with the aid of a broker/dealer. Bond and preferred stock funds are also examples of income funds. which decreases on a yearly basis. Prospectus . These funds are also purchased with the aid of a broker/dealer.289 • • Public Offering Price (POP) – Net Asset Value of a fund adjusted for front-end sales charges. which are generally 1% or less.some funds charge a redemption fee. the bid and ask prices are normally the same. • No Load funds generally do not have sales charges.are the fees paid to fund managers. A mutual fund that invested primarily in fortune 500 companies would be an example of a stock fund. mutual funds that invested in high-tech companies such as Intel. At the same time. or geographical area (companies based in Europe). and Netscape have reaped the benefits of the tremendous growth in these companies. For example. A primary objective of these funds is to preserve capital (hopefully with a modest increase) and produce a moderate income. many high-tech companies failed. Balanced Funds Balanced mutual funds invest in a mix of bonds. In general the stock holdings tend to be more conservative to reduce the fluctuation in the price.g. For example. and preferred stock. technology).g. the funds suffered losses. 290 .. high-tech mutual funds performed very well in the mid-1990s. common. F. The primary objective of a specialized fund is to focus on a particular market and to diversify investments in companies within that market. Microsoft. A growth fund has increased risk because funds are invested in companies and fields where there is “speculation” that the company will grow.. and the capability for the fund manager to invest in multiple companies with growth potential (in other words.290 C. related industry (e. Growth Mutual Funds Growth mutual funds are funds that invest primarily in companies that have excellent potential for growth. E. Stock Funds Stock mutual funds are funds that invest primarily in stocks. and as a result. energy companies). Unlike a balanced or income fund. diversify). D. The primary objective of a growth fund is to have an appreciation in the value of shares. An advantage of a growth fund for an investor is the research capability of the fund manager and firm. a stock fund invests primarily in equities. Specialized (Sector) Funds Specialized (Sector) mutual funds are funds that invest primarily in a particular industry (e. Unit Investment Trust (UIT) Unit investment trusts are a common type of investment company. The owner invests in the annuity contract. After the shares are purchased. the sponsor elects a fixed portfolio (usually bonds) and places the portfolio in a trust. generally no buying or selling of securities takes place in that portfolio. There are two types of Unit Investment Trusts. the trust buys shares of a management company. An annuity is classified as either a deferred annuity or an immediate annuity. the insurance company guarantees the investor a specified interest rate for a specified period. 2. A deferred annuity allows the owner to elect to defer annuity payments for a period in excess of one year. These shares are used to fund annuity contracts issued by insurance companies (variable annuities). The units are redeemable with the trust sponsor at their Net Asset Value. As the investments within the trust mature or are called. Investors receive current income from the paying agent either monthly. the insurance company assumes the risk of the portfolio. In a fixed annuity. When all of the investments have matured. quarterly or semi-annually. The unit represents an undivided interest in a portfolio of securities. In the case of a deferred annuity. In the case of the variable annuity. In the case of an immediate annuity. Fixed Annutities – The fixed annuity can serve either as a deferred or immediate annuity. They differ from the investment companies that offer mutual funds. A UIT issues “shares of beneficial interest” or “units” (compared to shares issued by a mutual fund investment company). They are: • Fixed UIT • Participating UIT Fixed UIT – In a fixed UIT. the trust self-liquidates. 1. Units of this portfolio are then sold to investors. the owner allocates the 291 . payments that represent a return of capital are made to investors. Variable Annutities – The variable annuity can also serve as either an accumulation vehicle or income-generating vehicle.291 UNIT 4: INVESTMENT TRUSTS This section discusses two types of investment trusts: A. the insurance company guarantees a specified dollar amount for a specified period. Participating UIT – In a participating UIT. Once the portfolio is selected. Unit Investment Trust (UIT) B. they are placed in the trust until the unit is redeemed. An immediate annuity provides an income stream beginning within one year of purchase. Real Estate Investment Trust (REIT) A. The Trust does not pay tax. When the annuitant dies. Joint and last survivor annuity – if the annuitant dies. REIT’s are normally taxed under Subchapter M of the IRS Code. This option usually results in a lower payment amount than the life annuity. the owner elects to receive payments on either a fixed or variable basis. • • Equity REIT – Invest mainly in properties. The insurance company makes no guarantee of performance. all distributions flow to the shareholder.292 investment among a variety of investment options. who must report the income on a personal tax return. then the payments continue for a specified minimum period. Real Estate Investment Trusts (REIT’s) Real Estate Investment Trusts (REIT’s) invest in real estate. In a variable annuity. These are: • • Life annuity – payments continue for the life of the annuitant. the estate of the annuitant receives a refund of the remaining value. This option usually results in the highest payment to the investor. 292 . Shares of beneficial interest in REIT’s are either listed on exchanges or trade OTC. • • B. Investors can always sell shares to another investor. The amounts received are treated as distributions of interest first (taxable) and recovery of cost second (non-taxable return of investment). Income tax is triggered when dollars are distributed from the contract. Unit refund life annuity – If the annuitant dies before receiving the full investment value from the annuity. the investor assumes the risk of the portfolio. short-term construction loans and mortgages. since the annuity covers the lifespan of two individuals. the payments stop. payments continue for the life of another person (usually the spouse). Life annuity with period certain – payments continue for the life of the annuitant. Both fixed and variable annuities offer several payment options at the time when income is desired. This payment option is less. Mortgage REIT – Invest mainly in mortgages and construction loans. The annuity’s return varies directly with the performance of the investment options. but if that person dies early. In the case of an income-producing vehicle. for example 10-year period certain. All annuities are tax deferred investment vehicles. The primary purpose of the Act is to require full and fair public disclosure of important elements in stock issues and to prevent fraud. Securities Act of 1933 The Securities Act of 1933 was the first legislation designed to regulate the sale of securities and associated activities. The prospectus is an abbreviated version of the registration. regulations have been developed by federal and state governments. 1. Some Requirements of the Act follow. Municipal Securities Rule Making Board F. Securities Exchange Act of 1934 C. including criminal and civil penalties. SEC Review process – before issues can be sold to the public. The S-1 statement includes the following: • Information on corporate officers and directors • nature of the business • financial information for the last 3 years • description of the how the proceeds from the issue will be used • amount of corporate holdings for all officers and directors and a list of all owners holding more than 10% of the securities • legal opinion • description of any legal actions pending against the company • articles of incorporation • fees for the underwriter of the issue. Securities Act of 1933 B. The following topics will be outlined in this Unit. 293 . and governing bodies for brokers. Registration Requirements – applies to all new securities sold through interstate commerce and requires registration with the SEC. the SEC must review the registration. The SEC has 20 days (called the cooling off period) to review the materials. A. 1. Registration is accomplished by filing a S-1 statement and a prospectus. Margin Lending A. Investment Company Act and Advisors Act of 1940 D.293 UNIT 5: REGULATIONS To help ensure that investors receive equitable treatment from companies and investors. The Act was designed to ensure that potential investors receive accurate and complete information. The Act is administered and enforced by the Securities and Exchange Commission (SEC). There are severe penalties associated with false or misleading information on S-1 statement. National Association of Securities Dealers Rules E. The Act specifically exempts certain securities from the registration requirements: These include: • Securities issues by the U. Note: the SEC may lengthen or shorten the cooling off period. its primary objective is to review the statements for completeness. it can suspend the process with a stop order. 3. The 1934 Act created the Securities and Exchange Commission (SEC). • Commercial paper that matures in less than 270 days. • Intrastate issues (Rule 147) . • Instruments that are covered by the Interstate Commerce Act (railroads and airlines for example).securities that are sold to selected investors and are not sold to the public. 294 . Securities Exchange Act of 1934 The Securities Exchange Act of 1934 was enacted to help prevent unfair trade practices on previously issued securities.securities are sold only to residents of the state where the issuer resides. The SEC has the power to issue the following: • Deficiency letters . Exempt Securities . • Issues of $1.after the SEC is satisfied. • Non-profit groups. The SEC never actually approves an issue or judges the quality of the issue.5 million or less (Regulation A small scale offerings that do not exceed $5 million for a 12-month period and must be filed with the SEC at least 10 days prior to the issue).letters that ask the issuer for more information or specific amendments to the registration. • Private placements (regulation D) .294 however. Government or agencies.while the SEC review is in progress. • Effective date .if the SEC believes that the registration statement contains false or misleading information or that pertinent information has been omitted. Preliminary prospectuses are often called “red herrings”. the issuer can circulate a preliminary prospectus to determine the interest in the issue. Preliminary Prospectus . Once the new information is received the SEC has additional time to review the information.S. • Stop orders . the effective date is established and sales may begin. 2. • Fixed annuity contracts and insurance policies. B. In other words. the 1934 Act regulated trading in secondary markets while the 1933 Act regulated new issues. The preliminary prospectus must include the following: • statement that the registration is filed but not effective • statement that information is subject to change • statement that it is not an offer to buy or a solicitation to sell • red ink to distinguish it from a final prospectus. • Obligations issued by state or other political subdivisions. the period is often longer than 20 days as the SEC may request additional information from the issuer. 295 . A copy of this information must also be submitted to the SEC. Some specific requirements of the Act include. then all participants in the proxy contest must register with the SEC. It is unlawful to generate false trading activities to give the impression that an issue is being actively traded or to provide misleading information to generate sales. The commissioners are appointed by the President and approved by the Senate. It should also be noted that all securities must be registered with the SEC.295 SEC – is the enforcing authority for the securities industry and is comprised of commissioners. Proxies – Regulations state that companies that solicit proxies from shareholders must provide detailed and accurate information regarding proposals to shareholders. agree to abide by the law. The SEC establishes rules to regulate the securities industry. and anyone who has information on the corporation not available to the public. They serve 5year terms and are prohibited from any business or stock activity during their term. Credit Regulations – Members of exchanges or broker/dealers are prohibited from borrowing on any listed security. and provide information regarding internal rules and regulations. Insiders are generally barred form short-selling. Other activities that are prohibited include short sales (preventing an investor from continually driving the price down by selling short only to eventually buy the securities back at reduced prices) and solicitations (soliciting purchases on an exchange). In addition. Individuals who are firm members and are engaged in securities transactions and interstate commerce must also register with the SEC. Registration Requirements – National securities exchanges must register with the SEC. Insiders must file a personal statement with the SEC and must report all personal security transactions in their corporation no later than 10 days after the end of the calendar month in which they occur. There are some exceptions to the registration requirements. Insider Rules – Insiders are not allowed to profit from their information by trading a stock before that information is public. anyone with 10% or more of the shares. except through a Federal Reserve bank. they are prohibited from having a total debt that is in excess of 15 times their net capital. There are possible criminal penalties for those who fail to register. Manipulation and Deception – Fraud and/or the manipulation of securities’ prices is prohibited by SEC regulations. Insiders include the officers or directors of a corporation. If a firm is trying to acquire another company (a proxy contest). such as small local exchanges and brokers that do not do business with the public. It should be noted that these regulations do not apply to exempt securities such as federal government obligations. Some specific regulations under this portion of the Act include: • • • Recommendations for a particular security to a customer by a broker/dealer must be determined to be reasonable and suitable for the customer. D. transactions. This includes developing a consistent method to open a new account and to maintain current and accurate records of customer accounts.000 prior to offering an investment to the public. Investment Company Act of 1940 The Investment Company Act (ICA) of 1940 was instituted to ensure that investors are fully informed and are treated fairly.are companies that promise to pay an amount at a future date in return for periodic payments from the investor. Supervision of all employees of a firm is required. Account documentation must be maintained for all customers. • • • Unit investment trust company . Broker/dealers involved with interstate commerce or transactions with national exchanges must register with the NASD.are companies which issue securities that represent an interest in a specified security. The NASD was established as part of the 1934 Act with the primary objective of regulating the over-the-counter (OTC) market. Board members must be elected by shareholders. Some of the requirements of the ICA are: • • • • • Sponsors must invest at least $100. correspondence. Fund managers can not exceed 60% of the Board. Management company .are investment companies that do not fit either one of the categories listed above. Face amount certificate company . The payment amount is the face value at maturity or a surrender value if it is redeemed prior to maturity. Section C for related information. National Association of Securities Dealers (NASD) Rules Note also see Unit 1. The Act specifically defines 3 types of investment companies.296 C. 296 . and customer complaints must be conducted. Changes to investment objectives or policies require a majority vote of the shareholders. All firms that are bound to abide by this Act. at least 40% of the Board must be outsiders. all customer complaints must be maintained. In addition. In other words. A contract that specifies the management fees must be developed and the fees should be reasonable and based on performance. are also subject to SEC regulations. The shares are redeemable and the holdings can be a mutual fund portfolio. Written procedures to promote adequate supervision must be developed and reviews of customer accounts. employees of the firm may not recommend nor solicit purchases of the firm’s stock.297 In general all broker/dealers must maintain detailed records to ensure that investors are protected. Firms are required to develop a training program for their employees. Registered representatives that leave the business for two years. The rules include: • • • • • • • The financial goals and current financial situation must be assessed in order to make suitable investment recommendations. then all discretionary transactions must be approved by a principal in a firm. Registered representatives are prohibited from charging customers for investment advice. However. All new accounts must be approved by a principal in a firm. The rules include: • • • • • • • All correspondence and all transactions must be reviewed and approved by the firm and maintained for 3 years. If a customer formally assigns power of attorney privileges to a representative. If agreed to by a customer. and must retake all required examinations. Summary accounting information must be distributed to customers annually and the SEC has the right to examine these records at any time. This includes maintaining accounting records and having a review by an independent accountant. Disputes between registered representatives and firms must be resolved through an independent binding arbitration process. customer disputes can also be settled by binding arbitration. 1. unsolicited purchases are acceptable. the customer must sign a statement regarding the suitability of the investment prior to the actual transaction. In effect to protect customers from unsubstantiated or undocumented losses. lose their licenses. Firms must maintain fidelity bond coverage on all employees to protect against losses due to theft or misappropriation of securities. If a firm’s stock is publicly traded. Conduct of Customer Account Rules . NASD has established some specific rules for registered representatives. Continuing education requirements are imposed on all registered representatives to ensure that satisfactory knowledge is maintained. Registered representatives are prohibited from giving gifts to anyone (related to their broker activities) in excess of $100 per year. Private transactions conducted outside the firm are prohibited.Were designed to provide a consistent and documented process to maintain customer records. In addition. Disciplinary actions regarding employees must be reported to NASD. High risk (“penny stocks” selling for less than $5 that are not listed on an exchange or NASDAQ) stocks may not be sold to investors until the customer’s financial position and market knowledge have been reviewed. Registered Representative Rules – NASD considers any person who solicits or conducts business in securities to be a registered representative. Registered representatives are also prohibited from: 297 . 2. Registered representatives are prohibited from guaranteeing a customer’s account against loss or from sharing in the losses or gains in an account. Deceptive quotes are prohibited and members must honor all quotes (can’t back-away). In other words. As with the NYSE. exempt securities and trades made on an exchange floor. All quotes and trade reports must be factual. • Advertising and sales literature must be approved prior to its use by a principal and the documentation must be retained for 3 years. Note also see Unit 1. Some specific rules in this area include. Section B. However. Some of the rules include: • • • • Trades can not be executed by a broker/dealer unless they have reasonable assurance that the customer will pay (for a purchase) or deliver (for a sale) within 3 business days of the transaction. Five percent has been set as a guideline. and does not mislead the public. it should be noted that this is not a rule. This includes payments to influence newspaper articles or investment services. however.4 for related information on the NYSE. Trading and Market Rules – NASD also designed these rules to protect consumers and to provide a consistent and equitable method to sell and purchase securities. the 5% guideline does not apply to mutual funds (8 ½% maximum sales charge rule). Communications with the Public – The NASD rules for communicating with the public are very similar to those used by the New York Stock Exchange. This includes lending margin securities without a signed loan consent • • • • 4. Payments of any kind to influence the market price of a security are prohibited. Manipulative or deceptive practices are prohibited. Improper use of customer funds and securities is prohibited. new issues sold under a prospectus. limited partnerships (10% maximum sales charge rule). the member must obtain the most favorable pricing for the customer. Commissions and mark-ups must be fair and reasonable. In a firm’s first year of operation this literature must be submitted to the NASD 10 days prior to its use. Payments designed to influence initial public offering price are also prohibited. The NASD also right to perform periodic checks of compliance.298 • • • • • excessively trading a customers account recommending purchases that are not suitable based on the customer’s financial capacity engaging in fraudulent activities such as trading without authorization or misappropriating funds soliciting the purchase of stock before the dividend date to promote the receipt of dividends trading in mutual fund shares (the registered representative may not make an inventory of mutual fund shares and act as a market maker for the company). Trades must be executed under favorable pricing conditions for the customer. Advertising materials are defined as 298 . NASD wants to ensure that information disseminated to the public is fair and accurate. 3. seminars. which includes mediums such as TV. In addition. the customer or firm may ask for a hearing and subsequently go through an appeal process if any of the remedies are not deemed acceptable. Sales literature includes form letters. it must be disclosed. The firm must respond in writing to the DBCC and a copy of the response is sent to the customer. Recommendations must be based in fact and the market price of the security must be included. 299 . brokers. They also must not mislead. these materials must contain the statement that past performance does not indicate that future results must be made. and NASD among others. FDIC. The Code outlines the process for handling a grievance. SEC. These include the Federal Reserve Board. the municipal securities market was unregulated.500. E. If compensated testimonials are used. The complaint is then forwarded to the District Business Conduct Committee (DBCC) which forwards the complaint to the firm. If a customer files a complaint against a firm or employee. make unwarranted claims. or promise specific results. and similar items. Depending upon the satisfaction of the remedy. Situations which are determined to be minor. The DBCC then determines if a violation has occurred and what actions. Although the MSRB promulgates regulations. are appropriate. newspapers. General standards for communication state that communications must be truthful and in good taste. only the market participants. Statements regarding investing advantages for a particular security must also include the corresponding risks. The MSRB is comprised of a 15-member board that creates regulations that apply to banks. research reports. generally results in the firm admitting guilt and the imposition of censure or a fine with a maximum of $2. The first step is the filing of the complaint (on a standard complaint form) to a NASD district office. it relies on other agencies to enforce its rules. if any. such a relationship must be disclosed. Past performance statistics must be for at least a 12-month period. It should be noted that the MSRB does not regulate municipal issuers. Municipal Securities Rule Making Board (MSRB) The MSRB was created in 1975 to develop rules and regulations to govern the municipal securities market. if the firm has a relationship with the stock such as ownership or any other interest. There are multiple steps in the process and the length of the process depends upon the customer’s and firm’s satisfaction with the remedy. the NASD Code of procedures is used. In addition. and periodicals. All reports must be clearly dated and reasonably current (generally within the last 6 months).299 • • • • • • materials for the mass market. Prior to the Board’s creation. and dealers engaged in municipal activities. etc. Registered Representative Rules – MSRB Rule G-2 requires that all parties effecting a municipal transaction must be qualified. trading. all new accounts must be approved in writing by a principal. they are not authorized to transact municipal business or receive commissions on municipal transactions. advising. of municipal securities). processing. clear.any person engaged in (preparing or approving financial reports. As mentioned previously. in order to make effective recommendations.300 1. • There is a 90-day apprentice period for new municipal securities representatives during which time they must pass the Series #52 or #7 exam. new accounts. Conduct of Customer Account Rules – The MSRB has established rules (similar to those discussed previously) to protect the customer. Firms or representatives may be disqualified if they willfully mislead the public. whose functions are not solely clerical. Municipal securities representative .any person engaged in management supervision. New accounts must be promptly reviewed by a principal. Also. communications. or direction of municipal sales activities (underwriting. • • • • • • • • 2. it may not be taken again for a period of 6 months. If an exam is failed. Every firm must have at least one principal. Such a person must have successfully passed the Series #27 (municipal securities financial and operations principal) exam. However. of municipal securities). advising.any person who is not a principal. etc. Such a person must have successfully passed the Series #52 (municipal securities representative) exam or the Series #7 (general securities representative) exam. communications. if you leave the business for 2 years you must retake the exam(s). they may be salaried employees during this period. trading. • Representatives may not solicit orders. Municipal securities financial and operations principal . it may not be taken again for 30 days. etc. tax status. or new customers without passing the appropriate exam. Municipal broker/dealers are required to deal fairly with all persons and can not engage in any deceptive or misleading practices. supervision of individuals that process. Some example of individuals and examinations are: • Municipal securities principal . are convicted of “money” related crimes. If an exam is failed 3 times. supervision of accountants. or been expelled by other organizations such as the SEC. researching. Qualified is generally determined by the passing of an appropriate examination. etc. Some specific provisions include: 300 . The MSRB requires that you assess the financial background. and who are engaged in (underwriting. etc. During this time. investment objectives. A copy of the MSRB manual must be maintained in each office and available to customer’s upon request. Municipal broker/dealers cannot give a gift greater than $100 to anyone (other than its employees) in the municipal securities business.). Such a person must have successfully passed the Series #53 (municipal securities principal) exam. or store municipal securities. All recommendations to customers must be based upon a knowledge of the customer and must be suitable for the customer. age. Customer complaints must be handled through a structured process and resolution must be approved by a principal. Firms can quote securities that it does not own if it can deliver the security. Municipal broker/dealers are prohibited from sharing in the gain or loss of a customer’s account. 3. address. This condition is often that the price is subject to change before the trade occurs. SSN. Although. All quotes must represent the broker/dealer’s best judgement of the fair market value of the securities.301 • • • • • • • • • Account information must include the name. All discretionary transactions must be reviewed by a principal by the end of the day of the transaction. and subject quotes. Municipal broker/dealers must disclose any relationships associated with a transaction in writing to a customer. Section A. nominal quotes. it can be made if the representative informs the customer of the unsuitability and the customers still directs that the trade be executed. Discretionary accounts (those where the representative has the authority to make trades on behalf of the customer without specific transaction approval) must be authorized in writing. Trading and Market Rules – The MSRB has established rules (they are similar to the new issue rules discussed in Unit 1. Subject quotes are ones that are subject to some condition.4) to govern the municipal market. Financial advisors to a municipality who assist in the structuring of a new offer. but a reasonable judgement based upon relevant factors such as possible market movements and the firm’s inventory of the securities. If a customer requests an unsuitable trade. it should be noted that the quotes are subject to change and to prior purchase or sale by another party. The form must be signed by the representative and a principal. If a customer refuses to disclose financial information. offers wanted (OW). Some of the rules include: • • All quotes must be “bona fide” whether they are written or oral. a recommendation can not be made. The quotes do not have to be the exact fair market value. and who want to be the underwriter. must resign from the advisor relationship and notify the municipality in writing that a conflict of interest exists and disclose the expected financial remuneration from the issue. Also records of complaints must be retained for 6 years. and type of account (note: margin accounts must be authorized in writing). Such quotes are prohibited if the firm has knowledge that the security is not available. Municipal broker/dealers are prohibited from guaranteeing a customer’s account against loss. Quotes can be in the form of bids wanted (BW). occupation. Nominal quotes are informational quotes that indicate that the firm is not willing to trade at those prices. • • 301 . the new issue bonds must actually be available (not completely pre-sold) to be advertised. Syndicate transactions must be filled in a specific order that has been determined by the manager. and may not be complete and accurate. the yields listed must have been in effect at the time of the publication. • • • 302 . The identity of customers for group net-orders must be disclosed to the manager to prevent one customer from purchasing too much of an issue. It should be noted that the complete official statement or offering circular is not considered an advertisement. New issues may be advertised and the initial yield offering may be included in the advertisement as long as the date of the initial sale is included in the advertisement. circulars. Any advertisement may not contain false or misleading information. Prices charged for municipal bond trades must be fair and reasonable. brochures. 4) Member takedown orders – any orders after all designated net-orders have been completed. • If a percentage rate is shown. This applies to both principal and agency trades. 2) Group net-orders – orders taken during an established time period after the bid has been won by a syndicate. form letters. Normal priority order is: 1) Pre-sale orders – orders taken by the syndicate prior to the date the underwriter was selected (usually applies to underwriting that was subject to a competitive bid). the broker/dealer must disclose whether the securities are for their own account. 4. Advertising and Other Rules – The MSRB has established rules to control the dissemination of materials to the public. the ad must state whether it is a nominal rate or yield and whether it is a pre. Since these documents do not contain all of the information included in the official document. This includes almost anything that is disseminated to the public such as notices. The basic definition of advertising is material designed for dissemination to the public through public media or promotional literature.302 • • • • Broker/dealers are prohibited from reporting information on a trade unless it is known that a trade occurred at that price. If transactions are submitted through a syndicate (a group of dealers). Some of the rules include: • Summaries or abstracts of official statement and offering circulars are included under these rules. In addition. It should be noted that internal memos or communications are excluded from this rule since they are not intended to be publicly distributed. and market letters. However. Secondary bond market advertising has the following rules: • If the advertisement shows yields or bond prices the information must be accurate as of the date of the advertisement. reprints. they are considered advertisements.or post-tax yield. False reports are considered to be a deceptive practice. 3) Designated net-orders – orders where a designated member of the syndicate may receive extra profit to complete the sale of an issue. a related account (one controlled by the dealer) or an accumulation account established by an investment trust. Rehypothecation – the practice of a broker pledging a customers securities with a bank or other loan source. • Regulation T – limits the amounts brokers can lend to customers on various types of securities. • F. it must be tax-free or all tax-related issues must be disclosed. which means that a customer pays $. Municipal securities transactions claims or disputes must be resolved through arbitration. Loan Value – the percentage of the security’s market value that the firm lends to the customer. Municipal dealers are prohibited from engaging in the municipal securities business for 2 years after a contribution is made to an elected official. • Regulation G – limits the amount a non-bank lender can lend to brokers who use customer securities (rehypothecate) as collateral. Brokers are not permitted to accept any additional compensation for the sale of the bonds other than those disclosed in the prospectus. Hypothecation – the practice of pledging securities as collateral. The advantage to a customer is the ability to leverage their money.50 for every $1 of security purchased.303 • • • • • • If current yield is included in the advertisement. The margin percentage varies depending upon changes in federal regulations. and the advertisement states that bonds are subject to change in yield and price. This includes contributions from PACs controlled dealers. the dealer will attempt to acquire the bonds if requested. Margin Lending Margin accounts are accounts where the broker/dealer extends credit to the customer and only a percentage of the purchase price is actually paid. If bonds are advertised as tax-free. Computerized Uniform Securities Identification Program (CUSIP) . However. If the margin requirement is 50% then the loan value is 50%. 303 . • Regulation U – limits the amount can be borrowed by brokers who use any customer securities as collateral. • • • The Federal Reserve Board has set regulations for margin accounts. • Dealers can advertise bonds which they don’t have in inventory if the material states: subject to availability. Some definitions associated with margin accounts are: • Margin – the percentage of the sale price the customer must deposit. All advertisements must be approved by a principal in the firm. It is usually between 40 and 60%. The margin amount is currently 50%. the yield to maturity or yield to call must also be included. in effect buy additional securities with less cash.numbers are assigned to all new issues and must be included in all sales confirmations. it should be noted that gifts of $250 or less are permitted. • New margin accounts must have a signed margin agreement in addition to the usual new account information. increase the equity balance) is required per Regulation T. • Special memorandum account . an additional line of credit is established for the customer. the excess amount may be used to purchase additional securities on margin. 304 . Other terms and definitions associated with margins are: • Long market value – is the customer’s gross cost and includes any charges and commission and is the amount used to calculate the margin requirement. • Maintenance calls .if the market price of securities rises and the equity balance exceeds the margin requirement. the actual margin amount is usually greater than 50%. and other issues from taxing entities. • Restricted accounts – if the equity balance declines in an account due to a decline in the market price of security and the current equity position falls below margin requirements. the customer is required to place cash or securities in their account within 48 hours or be subject to the sale of shares from their account. Since they involve credit it was determined that special requirements were needed. The margin agreement should state that all transactions are subject to pertinent laws and regulations. For example. the account is classified as restricted. thus. NASD and NYSE have rules that require at least 25% equity in a long account. firms can assign a higher loan value to them.if the equity position in an account falls below the 25% threshold. The customer must also agree to: • Allow the brokerage firm to pledge or repledge securities for broker loans • The accrual of interest charges on debt balances in their account • Permission to sell held securities with or without notifying the customer if equity is not adequate • Some individuals who work for exchanges (and their spouses) may require special approval from their employer before a margin account can be opened. To calculate the equity. Also a registered representative may not open a margin account without branch manager approval. state or municipal government issues. mew margin accounts have a $2. In addition. These include federal government debt issues. • Certain securities are exempted from regulation T margin requirements.e. Since these issues are exempt. only the new purchases are subject to the original margin requirement. Restricted accounts are subject to specific rules. Although no funds actually change hands.000 minimum value of an account that is added to the margin amount. • Equity – the customer’s net worth in their account. • Industry requirements . • Debit balance – is amount of the loan to the customer from the firm.304 There are special characteristics associated with margin accounts. subtract the debit balance from the long market value. however. If additional securities are purchased. • Only listed securities (those listed on national exchanges) and or securities listed on an OTC margin list (which is updated regularly) may be traded on margin per regulation T.NASD and NYSE have established some margin requirements (voluntarily) that are more strict than Regulation T. no specific action on the account (i. Long call II. To get immediate execution WITHOUT restrictions or limits. Secondary Market. 5. Primary Market. B. Over the Counter Market.305 STUDY QUESTIONS FOR VOLUME 4 SECURITIUES INDUSTRY 1. Real estate taxes C. 6. B. I and III I and IV II and III II and IV 2. The New York Stock Exchange is an example of a(n) A. Long put III. all or none (AON) order. Lease rental payment. C. B. is outstanding stock repurchased by the company. Tertiary Market. C. C. good till canceled order. An individual soliciting the sale of a closed-end corporate bond fund to a customer in the secondary market would need to be registered as: A. D. has voting rights. Treasury stock A. Series 6 Investment Company/Variable Contract Representative. B. an order should be placed as a(n) A. C. is authorized but unissued. fill or kill (FOK) order. Fines B. market order. D. Short put A. Series 7 General Securities Registered Representative. Series 1 Post-IPO Securities Representative. Which two of the following option strategies would be profitable in a declining market? I. B. 305 . receives dividends. 3. D. D. C. A revenue bond might be backed by which of the following? A. Sales taxes D. Short call IV. 4. Series 52 Municipal Securities Representative. no change The Securities Investors Protection Corporation was formed to protect: A. Standardized contract between two parties in which the buyer. in return for a fee.5 million shares B. B. SEC. C.306 D. $15 par value and 1. investor’s margin accounts in the custody of brokers. C. IRS XYZ Company stock has 2 million shares outstanding at $15 par value. 306 . investors from fraudulent financial statements issued by brokers. D. $10 par value and 3 million shares outstanding C. receives cash payments from the seller at a future date if the specified interest rate exceeds the strike price. D. What is the new par value and the number of shares outstanding? A. Individually negotiated contract to purchase or sell specified financial instruments on a future date at a specified price. Individually negotiated contract between two parties in which the buyer. 7. D. MSRB. The primary authority regulating the issuance of industrial revenue bonds is the A. 9. investor’s cash and securities if the broker fails and is liquidated. Which of the following is a futures contract? A. investors from abusive trading practices of brokers. receives cash payments from the seller at a future date if the specified interest rate exceeds the strike price. B. in return for a fee. $7. C. B. Standardized contract to purchase or sell specified financial instruments on a future date at a specified price.5 million shares outstanding D. 10. 8.50 par value and 2. XYZ declares a 3 for 2 split. NASD. 3.com # 1. P. and corrections to: NAFSA.O. 6. 5. Page # Comment 2. 7. Comments. 8. Athens.307 Appendix A Questions. suggestions. 10. 11. 9. 307 . GA 30604 (706) 353-3898 or acaple@cannonfinancial. Box 48357. 4. or Corrections Concerning the CFSA Study Guide Please forward comments. 17. 15. Zip: ___________________________________________________________________________ Phone: (_____)_____________ Fax: (_____)________________ E-mail: ____________________________ 308 . 13. 20. 19. State.308 12. 18. INFORMATION Name: ___________________________________________________ Date: ______________________ Company: _______________________________________________________________________________ Address: _________________________________________________________________________________ City. 16. 14. Substantive tests to evaluate the reasonableness of financial information. C. 4. Annual audit plan. Inverse. 6. and interim input reconciliations. Organizational status and objectivity. A. 9. Program change control. III. 10. Appraise the organization's internal control system. and IV only. 2. A. B. A. C.309 Appendix B Study Question Answers – Volume 1 1. Identifying opportunities for improvement in performance of key functions. 8. C. B. II. 309 . Collecting payments on accounts and reconciling accounts receivable records. Will use the CFSA designation with pride and professionalism. C. 3. 5. segregation of duties. 7. D. B. A. 8. 9. C. Currency and checking accounts only. C. I and III only. 3. D. As a sale of the lessor and a purchase by the lessee. D.310 Study Question Answers – Volume 2 1. The activity date used to determine dormancy is updated by internal debit memos. Commercial loans. I. II. 10. B. III and IV. A fee is charged for the internal audit of the plan. 4. A. 6. III and IV only. B. I. Enter into an interest rate swap to receive floating and pay fixed rate payments. D. 2. 5. 7. Conducting currency transactions in a manner to avoid reporting requirements. 310 . 311 Study Question Answers – Volume 3 1. II and IV only 4. An umbrella policy to place a protective umbrella over existing coverage. I and III only 2. and the claim should be placed against the agency’s Errors and Omissions policy for reimbursement of the claimant. C. 311 . 5. D. Unearned premium reserve. B. Deferred acquisition costs. 10. 6. B. Stock and mutual funds. 7. The claim should be denied since coverage was never present. C. C. C. B. C. Keogh plans 9. III and IV 8. Vesting 3. A. 2. A.2.htm – on May 14. B. 1999 iv Some information was derived from. Market orders are executed immediately at the best available market price if the stock is trading.html v COBIT .htm – on May 14. Copyright 1996 Grant Thornton LLP. Information Systems Audit and Control Foundation. May 2000 . D. Shorting calls allows the seller to buy the calls back at a lower price. Being long puts allows the holder to sell at a higher price as the value of the put increases. 2nd edition i 312 . A 3 for 2 stock split simply means that there will be 1. 10.gt. C.com/gtonline/assuranc/handtoc. 4. The sale of closed-end investment company shares are treated like a general security. 1999.org/aboutiia/about. 8.5 times as many shares outstanding at 2/3 of the value as prior to the split. pgs. April 1998.pg. 9. AICPA Brokers and Dealers in Securities. non newly-issued securities which are usually offered by an underwriting syndicate.http://www. 3.org/aboutiia/about. B. Control. Committee on Basic Auditing Concepts. 6. ii Information on IIA taken from their web site -. The sale of general securities must be sold by a general securities registered representative (Series 7).http://www. B. p. The Municipal Securities Rulemaking Board is the primary regulator of IRB’s and all Municipal Securities. and Audit for Information and related Technology. Regulations NASD Rules. The NYSE trades in secondary securities.theiia. B. There is no change in the total amount of capitalization. Calls decline in a declining market. 13 and 14. D. http://www. and puts increase in value in a declining market. In this case that equates to choice B. A statement of basic Auditing Concepts. iii Information on IIA taken from their web site -. 1973. 10. Handbook For Audit Committee Members. C. The others back general obligation bonds. that is. See AICPA Brokers and Dealers in Securities.312 Study Question Answers – Volume 4 1. May 2000.theiia. without restrictions or limits.Governance. Sarasota FL: American Accounting Association. 5. B. 7. 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