chapter 13 substantive audit testing: financing & investing cycle& completing the audit

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CHAPTER 13Substantive Audit Testing: Financing & Investing Cycle&

Completing the Audit

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What are the major accounts What are the major accounts of the capital acquisition and of the capital acquisition and

repayment cycle? repayment cycle? -Long term liabilities- stock accounts- donated capital- retained earnings and appropriations- dividends declared and payable

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In auditing the capital acquisition In auditing the capital acquisition and repayment cycle, the auditor and repayment cycle, the auditor

should consider:should consider:

Relatively fewtransactions affect the

account balances, but eachtransaction is often highly

material in amount.

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The exclusion of a single transac-

tion could be materialin itself.

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There is alegal relationship be-

tween the client and theholder of the stock, bond,

or similar ownershipdocument.

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There is adirect relationship be-

tween the interest and divi-dends account and debt

and equity.

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- proper authorization for issues of notes or bonds- adequate controls over payment of interest and principal- adequate documents and records- periodic independent verification

In auditing the internal controls In auditing the internal controls related to long-term liabilities, related to long-term liabilities,

the auditor will consider:the auditor will consider:

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- completeness- accuracy- presentation and disclosure

What are the primary audit What are the primary audit objectives with regard to long-objectives with regard to long-

term liability account balances?term liability account balances?

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long-term liabilities audit procedureslong-term liabilities audit procedures

perform analytical

proceduresto test the

reasonablenessof long-term liabilities and

interest expense

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inquire of management

regarding:- completeness of liabilities- debt-related restrictions on assets- ability to pay interest

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review contractual provisions of

long-term liabilities- consider pledging of assets related to debt (disclosure)- determine client adherence to contractual requirements (payment dates, working capital, ratios)

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confirm debt balances, interest payments, and client compliance with

contractual agreements with the creditors

auditor

creditor

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for all long-term liabilities,

recalculate interest expense, interest payable,

and amortizations of discounts or

premiums

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Trace receipt of borrowed amounts from cash receipts journal to bank statement


cash receipts journaldescription _ $$ _May 23, 19x7Wachovia loan 14,000

Bank Statement5/31/x7

Deposits:5/23 $14,000

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Trace receipt of borrowed amounts from cash receipts journal to bank statement to deposit

slips




Deposits:5/23 $14,000

DepositSlip

5/23/x7

14,000

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Trace receipt of borrowed amounts from cash receipts journal to bank statement to deposit

slips to debt agreement.




Deposits:5/23 $14,000

Debt Covenant Wachovia Bank hereby loans Ace Co. $14,000 on 5/23/x7

DepositSlip

5/23/x7

14,000

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Trace payments of principal and interest from cash payments journal to bank statement


cash payments journaldescription _ $$ _November 23, 19x7interest payment- Wachovia loan 700


Deposits:

Payments:

11/26 $700

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Trace payments of principal and interest from cash payments journal to bank statement to

cancelled checks to debt agreement.

cash payments journaldescription _ $$ _November 23, 19x7interest payment- Wachovia loan 700



Deposits:

Payments:

11/26 $700

Debt CovenantAce agrees to pay semi-annual interest of 10% on principal.

Ace Corporation 324

$ 700.00Wachovia Bankpay to the order of

date 11/23/x7

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What are the auditor’s What are the auditor’s primary concernsprimary concerns with regard to with regard to owners’ equityowners’ equity??

- authorization- presentation and disclosure- accuracy

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owners’ equity audit proceduresowners’ equity audit proceduresperform

analytical proceduresto test the

reasonablenessof owners’

equity accounts (including dividends)

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READ:- articles of incorporation, bylaws- minutes to meetings

Notediscussion of dividends, stock

options, stock issues, etc.

owners’ equity audit proceduresowners’ equity audit procedures

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Confirm shares outstanding withthe independent registrar and the

stock transfer agent.

- independent registrar - a third party paid by the client to ensure that stock is issued in accordance with the char- ter and board’s directions (required for SEC companies)


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Confirm shares outstanding withthe independent registrar and the

stock transfer agent.

- stock transfer agent - a third party paid by the client to maintain stockholder records and, possibly, to disburse dividends


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If the client does not use an independent registrar

and stock transfer agent, the auditor must examine the stock certificate records

and test any changes.


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Trace receipts from stock issues from cash receipts journal to bank statement to deposit

slips to board minutes.

cash receipts journaldescription _ $$ _May 23, 19x7Joe Ace 23,000


Deposits:5/23 $23,000

DepositSlip

5/23/x7

23,000

BoardMinutes

... sell JoeAce 2300additionalcommon...


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Trace payments related to dividends and treasury stock from cash payments journal to bank

statement to cancelled checks to board minutes.

cash payments journaldescription _ $$ _January 23, 19x7dividend distribution 4300


Deposits:

Payments:

1/26 $4300

Ace Corporation 324

$4300.00Stockholderspay to the order of

date 1/23/x7

BoardMinutes

... declaredividends of $4300...


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Recalculate dividend distribution to common and

preferred shareholders.

preferredcommon

consider features of preferred(cumulative, participating)


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Ace Company

1 share of commonstock

Ace Company


Ace Company


Inspect treasury stock; recalculate treasury stock

transactions.

Ace Company



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If all other accounts have been audited with satisfactory results,

Is the audit of Is the audit of retained earnings retained earnings

necessary?necessary?Possibly not, but the audit of retainedearnings is typically not time-consumingand may serve as a check on the auditof other accounts.

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Analyze all changes in

retainedearnings.


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Audit Completion ProceduresAudit Completion ProceduresSearch for unrecorded contingent liabilities.

What is acontingent

liabilityand whatare the

related SFAS 5 rules?

a potential futureobligation to an outside party for an unknown amount resulting from activities that havealready taken place

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What is acontingent



probable and reasonably estimated - accrual with footnote disclosure

reasonably possible - footnote disclosure

remote - no financial statement effect

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What is acontingent



Footnote disclosureshould describe the contingency and theopinion of legalcounsel or manage-ment regarding theexpected outcome.

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Jill Auditor, CPA

Joe Lawyer

Audit Completion ProceduresAudit Completion ProceduresSearch for unrecorded contingent liabilities.- inquire of management- review: ~ client copies of IRS correspondence ~ minutes to board and stockholder meetings ~ invoices from client attorneys ~ existing audit workpapers- obtain letters of confirmation from all client attorneys

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The auditor should ask the client to prepare a letter (on client letterhead, signed by client officer) asking the attorney to respond directly to the auditor concerning:- all material pending threatened litigation, claims, or assessments with which the attorney has been involved- all likely, material unasserted claim or assessments with which the attorney has been involved- the status of each claim or assessment- any additional, unlisted legal actions

Attorney InquiryAttorney Inquiry (AU 337) (AU 337)

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The client’s letter to the attorney should request that the law firm describe anyreasons for limiting their response.


The client’s letter to the attorney should alsoremind the law firm that they are responsiblefor telling the client when a legal matter should be disclosed.

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If an attorney refuses to respond or refuses to provide adequate information, the audit opinion will be qualified or disclaimed.


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12/31 2/14 2/28

balance sheet field work report date completion issue date

period under audit subsequent events period

types of subsequent eventstypes of subsequent events1.events that provide additional evidence about conditions that existed at the balance sheet date (e.g., settlement of liabilities, realiza- tion of assets)

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1.events that provide additional evidence about conditions that existed at the balance sheet date (e.g., settlement of liabilities, realiza- tion of assets)

types of subsequent eventstypes of subsequent events

Client financial statements for the periodunder audit must be adjusted to reflectthis subsequent event information.

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2. events that occur after the balance sheet date and do not relate to conditions that existed at year-end (e.g., bond/stock issue, acquisition, fire/flood loss, major customer/vendor bankruptcy)


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2. events that occur after the balance sheet date and do not relate to conditions that existed at year-end

disclose

These subsequent events must be disclosed in the footnotes of the period under audit. Theauditor may also consider:- pro forma financial statements- additional paragraph in audit report


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Joe Lawyer

Jill Auditor, CPA

Subsequent Events Auditing ProceduresSubsequent Events Auditing Procedures Near field work completion, auditors should:- read post-balance sheet interim statements- obtain a management representation letter- read minutes to board and stockholder meetings that have occurred since year-end- obtain letter from client’s attorney

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- the auditor is not responsible for dis- covering subsequent events during this period

- if, however, auditors learn of a subsequent event during this period, they are responsible for its disclosure

Whatresponsibility

does the auditorhave for

subsequentevents that

occur betweenfield work

completion andthe issue date?

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If auditors learn of a subsequent event during this period, they are responsible for

its disclosure.12/31 2/14 2/28



The auditors then have two options:- expand all subsequent events tests to the date of the event and change the report date to the date of the event (e.g., 2/21)- restrict testing only to matters relating to the new event and dual-date the report:

Taylor & Tower, CPAsFebruary 14, 19x1, except for Note 3, as to which the date is February 21, 19x1

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If theanswer to

any of these questions is

no, theauditors donot need to

take anyaction.

With regard to this information,auditors must determine:- did the information exist at the report date?- is this information reliable?- would the audit report have been different if the information had been available prior to the report date?- are persons still relying on the audit report?

period subsequent events period under audit

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If theanswer to

all of these questions is

yes, theauditors mustact to prevent

future reliance on the

audit report.

With regard to this information,auditors must determine:- did the information exist at the report date?- is this information reliable?- would the audit report have been different if the information had been available prior to the report date?- are persons still relying on the audit report?

period subsequent events period under audit

12/31 2/14 2/28


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the client must reviseand reissue the

financial statements

How do auditors How do auditors prevent future prevent future reliancereliance on a on a previously-issuedpreviously-issued

audit report?audit report?If the financial statement effect of the subsequently-discovered information

can be determined promptly

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the client must notify persons known to be (and those likely to be) relying

on the financial statements

How do auditors How do auditors prevent future prevent future reliancereliance on a on a previously-issuedpreviously-issued

audit report?audit report?If the financial statement effect of the subsequently-discovered information

cannot be determined promptly

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What should the auditor do if the client What should the auditor do if the client refusesrefuses to reissue the statements or contact to reissue the statements or contact

those relying on the auditors’ report?those relying on the auditors’ report?- first, notify each board member of management’s refusal- then: ~ inform client management that the audit report may no longer be associated with the statements ~ notify regulatory agencies that the audit report may not be relied upon ~ notify persons known to be relying on the statements that the audit report may not be relied upon

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Client Representation LetterClient Representation Letter (AU 333) (AU 333)The auditor must obtain a letter from the client documenting the client’s represen-tations during the engagement.

The primary purposes are to:- confirm and document oral statements- reduce auditor-client misunderstanding

The letter should be signed by the clientCFO and CEO and dated with the fieldwork completion date.

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Client Representation LetterClient Representation Letter (AU 333) (AU 333)

If the client refuses toIf the client refuses togive the auditor a give the auditor a

representation letter, representation letter, the auditor must the auditor must qualifyqualifyor or disclaimdisclaim the opinion. the opinion.

probable

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Final Audit StepsFinal Audit Steps1. Incorporating all audit evidence, materiality, and judgment, the auditor draws overall conclusions and prepares the audit report.2. The auditor prepares the management letter.3. The auditor communicates the results to the audit committee and gives them the audit report and management letter.

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AU 380 requires auditors to AU 380 requires auditors to communicate (oral or written) to the communicate (oral or written) to the

audit committees of audit committees of SEC CompaniesSEC Companies::- the auditor’s responsibilities under GAAS- significant accounting policies selected by management- significant financial statement adjustments- disagreements with management- difficulties in performing the audit

chapter 13 substantive audit testing: financing & investing cycle& completing the audit

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