Final answer:
The auditor is most likely to test for understatements of liabilities. The valuation of loans in the secondary market is influenced by the borrower's payment history and changes in economy-wide interest rates. Analyzing financial asset risk and considering key investment factors are crucial for effective financial market participation.
Step-by-step explanation:
The auditor will most likely perform extensive tests for the possible understatement of liabilities. When auditing, the focus on liabilities is due to the risk of a business not recognizing or underreporting what it owes, which can make the company appear more financially stable than it actually is. In contrast, overstating revenues, assets, or capital tends to raise a red flag regarding a company's revenue recognition or asset valuation practices.
Regarding the money listed under assets on a bank balance sheet, it may not actually be in the bank because banks operate on the principle of fractional reserve banking, which means they are required to keep only a fraction of their deposits on hand as reserves. The rest of the money can be loaned out or invested, which generates income for the bank.
When buying loans in the secondary market, an investor might pay more or less for a given loan depending on several factors:
- If the borrower has been late on a number of loan payments, the risk of default is higher, and thus the loan would be less valuable, leading to a lower price.
- When interest rates in the economy as a whole have risen since the bank made the loan, the existing loan's lower interest rate makes it less attractive, so it may sell for less.
- If the borrower is a firm that has just declared a high level of profits, the risk of default is lower, making the loan more valuable and potentially leading to a higher price.
- If interest rates have fallen since the loan was made, the loan is more attractive due to its higher interest rate relative to new loans, potentially selling for more.
Analyzing the risk involved in different types of financial assets is crucial for banks, as the value of their assets, which are primarily loans, depends on repayment risk. This risk assessment is complex and takes into account various factors, including economic conditions, the borrower's financial health, and changes in interest rates.
For investors in the financial market, key considerations include the risk-return tradeoff, the time horizon of the investment, market conditions, and the creditworthiness of borrowers, among other factors. These elements guide investment decisions and the pricing of financial assets.